medium · FRM Part 1 Foundations of Risk Management

An incentive-compensation scheme pays traders an annual bonus equal to a share of profits with no clawback and no penalty for losses below the bonus floor. A risk officer warns this creates a specific agency problem that no amount of better VaR measurement can fix. The most precise characterization of the embedded distortion is:

1. The asymmetric payoff gives the trader a long-option-like exposure to the firm's results, rewarding upside while capping personal downside at zero, which rationally incentivizes taking on negatively skewed, high-tail-risk strategies that look profitable until a rare blow-up
2. The scheme is actually efficient because paying traders a straightforward share of profits perfectly aligns their personal interests with those of shareholders, so the risk officer's stated concern simply reflects a basic misunderstanding of sound incentive design
3. The distortion described here is purely a measurement problem, and enforcing a sufficiently accurate, continuously monitored firm-wide VaR limit on a daily basis at all times would render the bonus structure fully incentive-compatible despite its underlying payoff asymmetry
4. The underlying problem is only that bonuses are paid annually rather than monthly under this compensation scheme, and simply shortening the payout frequency to better match the desk's trading horizon would on its own remove the incentive to quietly load up on hidden tail risk

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