This question considers two employees: (1) a sales manager, and (2) a stock trader. The sales manager has decision rights over which customers to call on the level of effort to put forth developing a strong product pitch. The sales managers performance is measured as total sales over a quarter. The stock trader works for a financial institution and has decision rights over which stocks she buys and sells using the financial institutions capital. The stock traders performance is measured as the P&L from the trades she makes over a quarter.

The stock traders quarterly P&L is the sum of the individual trade P&Ls. If during the quarter she buys 10,000 shares of a particular stock at $41 per share using the financial institutions capital and later sells the shares for $43 per share the P&L of the trade is ($43-$41)*(10,000) or $20,000. The P&L is a profit to the financial institution. If she sells the stock at $35, then the P&L is ($35-$41)*(10,000) or -$70,000.

Effort exerted by the stock trader to study the market will improve her P&L. Finally, note that some stocks have very volatile returns (the price can change a great deal in a short period of time) while other stocks have low return volatility (the price changes less high return volatility stocks in a short period of time).

The standard incentive contract pays the employee a bonus equal to a percentage of measured performance above a target level of measured performance when measured performance exceeds the target level.

1. While a standard incentive contract will reward the effort made by the sales manager and stock trader, how could the standard incentive contract induce the stock trader to make choices that are not in the financial institutions best interests?
2. How could the standard incentive contract be modified to reduce the stock traders incentives to make choices that are not in the financial institutions best interests while still providing the stock trader and incentive to put forth effort to make more profitable trades.