Employee Stock Options Incentive Effects: A CPT-Based Model
Bahaji, Hamza (2011), Employee Stock Options Incentive Effects: A CPT-Based Model, in Prachalias, Chrysovaladis, Proceedings of the 8th International Conference on Applied Financial Economics - Vol A, National and Kapodistrian University of Athens : Athènes, p. 499-508
TypeCommunication / Conférence
Conference title8th International Conference on Applied Financial Economics
Book titleProceedings of the 8th International Conference on Applied Financial Economics - Vol A
Book authorPrachalias, Chrysovaladis
Number of pages600
MetadataShow full item record
Abstract (EN)This paper examines the incentives from stock options for loss-averse employees subject to probability weighting. Employing the certainty equivalence principle, I built on insights from Cumulative Prospect Theory (CPT) to derive a continuous time model to value options from the perspective of a representative employee. Consistent with a growing body of empirical and experimental studies, the model predicts that the employee may overestimate the value of his options in-excess of their risk-neutral value. This is nevertheless in stark contrast with a common finding of standard models based on the Expected Utility Theory (EUT) framework that options value to a riskaverse undiversified employee is strictly lower than the value to risk-neutral outside investors. In particular, I proved that loss aversion and probability weighting have countervailing effects on the option subjective value. In addition, for typical setting of preferences parameters around the experimental estimates, and assuming the company is allowed to adjust existing compensation when making new stock option grants, the model predicts that incentives are maximized for strike prices set around the stock price at inception. This finding is consistent with companies’ actual compensation practices that standard EUT-based models have difficulties accommodating their existence.
Subjects / KeywordsStock-options; Cumulative Prospect Theory; Incentives; Subjective value
JELJ33 - Compensation Packages; Payment Methods
J44 - Professional Labor Markets; Occupational Licensing
G13 - Contingent Pricing; Futures Pricing
G32 - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
M12 - Personnel Management; Executives; Executive Compensation
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