Incentive fee resembling put option

CFA Level III
#1

Book 1, Exam 1, Q49.

The comment states that incentive fee contract (20% on profits) resembles put option owned buy manager.

The answer states that’s it’s wrong and that incentive fee contract resembles call option, explaining the logic.

I agree with the logic, but it can be easily twisted so that the contract resembles the put option. If performance (annual profit) is asset owned by manager, he essentially owns a put with strike 0 and sells it at price above 0 if profit is positive or sells at 0 if negative. What’s wrong with this logic?

#2

Not sure which book or question you’re specifically referencing, but if he owns a put on the incentive fee and the fee rises the put is out of the money. So when you say

“Sell it at a price above 0 if profit is positive” - that’s a call. The put wouldn’t have inherent value (ignoring time) if the underlying price is > strike. The call gains value as the underlying (incentive) rises which would match up with the question.

Am I reading your logic incorrectly? I could be misunderstanding your question.

#3

My logic is that performance is the asset that manager owns. Manager also owns a put on this asset with strike 0.

If performance is positive, manager sells it at its intrinsic price to the client. If performance is negative, manager executes put and sells it at 0.

#4

Even more detailed:

  1. Client’s contractual obligation to pay 20% of profits is an asset that manager owns (I think makes sense). But manager also holds a put option that allows selling this asset at 0.

  2. If profit is positive, the value of contractual obligation is positive from manager’s perspective and manager holds it.

  3. If profit is negative, the value of contractual obligation is negative from manager’s perspective and manager sells it for 0.

#5

I see what you’re saying. I think your logic would make sense if the question specified a PROTECTIVE put (what you’re describing when underlying is owned) versus a put w/ no underlying, but it doesn’t say that. So they key difference is you’re assuming the underlying is owned. I’d say the main idea of the question is that in terms of the incentive, the manager has no downside risk because the lowest is 0 and not negative, but upside potential which resembles a call. No underlying is owned.

#6

Yeah, makes sense. Thanks.