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Why do employees like to be paid with Options?: A multi-period prospect theory approach

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  • Sun, Lei
  • Widdicks, Martin

Abstract

The use of options as compensation for non-executive employees is a puzzle. Standard, rational, valuation models show that the cost of issuing options is larger than the value placed on the options by employees. Existing explanations for this puzzle are based upon static models that ignore the considerable dynamic aspects of employee stock option pricing and exercise behavior. We develop dynamic, multiperiod models of employee preferences considering risk aversion, loss aversion, overconfidence and probability weighting to test possible explanations of the use of employee stock options. We find that a cumulative prospect theory model generates scenarios where employees would prefer options to either cash or equity payments, and also optimally exercise their options early. This is the only model where options are preferred and also optimally exercised early.

Suggested Citation

  • Sun, Lei & Widdicks, Martin, 2016. "Why do employees like to be paid with Options?: A multi-period prospect theory approach," Journal of Corporate Finance, Elsevier, vol. 38(C), pages 106-125.
    • Handle: RePEc:eee:corfin:v:38:y:2016:i:c:p:106-125
    DOI: 10.1016/j.jcorpfin.2016.03.002
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    Cited by:

    1. Hana Urbancová & Markéta Šnýdrová, 2017. "Remuneration and Employee Benefits in Organizations in the Czech Republic," Acta Universitatis Agriculturae et Silviculturae Mendelianae Brunensis, Mendel University Press, vol. 65(1), pages 357-368.

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    More about this item

    Keywords

    Employee stock options; Prospect theory; Overconfidence; Early exercise;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods

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