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Incentives from stock option grants: a behavioral approach

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  • Hamza Bahaji
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    Abstract

    Purpose – This paper aims to analyze the valuation of stock options from the perspective of an employee exhibiting preferences as described by cumulative prospect theory (CPT). In addition, it elaborates on their incentives effect and some implications in terms of design aspects. Design/methodology/approach – The paper draws on the CPT framework to derive a continuous time model of the stock option subjective value using the certainty equivalence principle. Numerical simulations are used in order to analyze the subjective value sensitivity with respect to preferences-related parameters and to investigate the incentives effect. Findings – 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. Moreover, 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. Finally, the model predicts that an executive who is subject to probability weighting may be more prompted than a risk-neutral executive to act in order to increase the firm's assets volatility. Originality/value – This research proposes an alternative theoretical framework for the analysis of pay-to-performance sensitivity of equity-based compensation that takes into account a number of prominent patterns of employee behavior that expected utility theory cannot explain. It contributes to recent empirical and theoretical researches that have advanced CPT framework as a promising candidate for the analysis of equity-based compensation contracts.

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    Bibliographic Info

    Article provided by Emerald Group Publishing in its journal Review of Accounting and Finance.

    Volume (Year): 10 (2011)
    Issue (Month): 3 (August)
    Pages: 200-227

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    Handle: RePEc:eme:rafpps:v:10:y:2011:i:3:p:200-227

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    Related research

    Keywords: Cumulative Prospect Theory; Employee behaviour; Incentives; Stock options; Subjective value;

    References

    References listed on IDEAS
    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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    1. Bruno Jullien & Bernard Salanié, 1997. "Estimating Preferences under Risk : The Case of Racetrack Bettors," Working Papers 97-39, Centre de Recherche en Economie et Statistique.
    2. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-91, March.
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    4. Bengt Holmstrom & Paul R. Milgrom, 1985. "Aggregation and Linearity in the Provision of Intertemporal Incentives," Cowles Foundation Discussion Papers 742, Cowles Foundation for Research in Economics, Yale University.
    5. Tversky, Amos & Kahneman, Daniel, 1992. " Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
    6. DeFusco, Richard A & Johnson, Robert R & Zorn, Thomas S, 1990. " The Effect of Executive Stock Option Plans on Stockholders and Bondholders," Journal of Finance, American Finance Association, vol. 45(2), pages 617-27, June.
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    18. Camerer, Colin F & Ho, Teck-Hua, 1994. "Violations of the Betweenness Axiom and Nonlinearity in Probability," Journal of Risk and Uncertainty, Springer, vol. 8(2), pages 167-96, March.
    19. Kevin J. Murphy & Brian J. Hall, 2000. "Optimal Exercise Prices for Executive Stock Options," American Economic Review, American Economic Association, vol. 90(2), pages 209-214, May.
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    22. Hamza Bahaji, 2009. "Contribution à l'analyse des déterminants du comportement d'exercice des porteurs de stock options : une étude empirique sur le marché Américain," Working Papers halshs-00512840, HAL.
    23. Loughran, Tim & Ritter, Jay R, 1995. " The New Issues Puzzle," Journal of Finance, American Finance Association, vol. 50(1), pages 23-51, March.
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    Cited by:
    1. Bahaji, Hamza, 2012. "Cumulative Prospect Theory, employee exercise behaviour and stock options cost assessment," Economics Papers from University Paris Dauphine 123456789/9550, Paris Dauphine University.

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