Employee Stock Options Incentive Effects: A Cpt-Based Model
AbstractThis 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 risk-averse 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.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by HAL in its series Post-Print with number halshs-00681609.
Date of creation: 30 Jun 2011
Date of revision:
Publication status: Published - Presented, 8TH AFE SAMOS 2011, 2011, Samos island, Greece
Note: View the original document on HAL open archive server: http://halshs.archives-ouvertes.fr/halshs-00681609
Contact details of provider:
Web page: http://hal.archives-ouvertes.fr/
Stock options; Cumulative Prospect Theory; Incentives; Subjective value.;
This paper has been announced in the following NEP Reports:
- NEP-ALL-2012-04-03 (All new papers)
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.:
- 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.
- Brian J. Hall & Kevin J. Murphy, 2000. "Optimal Exercise Prices for Executive Stock Options," NBER Working Papers 7548, National Bureau of Economic Research, Inc.
- Jensen, Michael C & Murphy, Kevin J, 1990.
"Performance Pay and Top-Management Incentives,"
Journal of Political Economy,
University of Chicago Press, vol. 98(2), pages 225-64, April.
- Chip Heath & Steven Huddart & Mark Lang, 1999. "Psychological Factors And Stock Option Exercise," The Quarterly Journal of Economics, MIT Press, vol. 114(2), pages 601-627, May.
- Ingolf Dittmann & Ernst Maug, 2007. "Lower Salaries and No Options? On the Optimal Structure of Executive Pay," Journal of Finance, American Finance Association, vol. 62(1), pages 303-343, 02.
- Mohammed Abdellaoui, 2000. "Parameter-Free Elicitation of Utility and Probability Weighting Functions," Management Science, INFORMS, vol. 46(11), pages 1497-1512, November.
- George Wu & Richard Gonzalez, 1996. "Curvature of the Probability Weighting Function," Management Science, INFORMS, vol. 42(12), pages 1676-1690, December.
- Holmstrom, Bengt & Milgrom, Paul, 1987.
"Aggregation and Linearity in the Provision of Intertemporal Incentives,"
Econometric Society, vol. 55(2), pages 303-28, March.
- 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.
- Kahneman, Daniel & Tversky, Amos, 1979.
"Prospect Theory: An Analysis of Decision under Risk,"
Econometric Society, vol. 47(2), pages 263-91, March.
- Amos Tversky & Daniel Kahneman, 1979. "Prospect Theory: An Analysis of Decision under Risk," Levine's Working Paper Archive 7656, David K. Levine.
- 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.
- Johnson, Shane A. & Tian, Yisong S., 2000. "The value and incentive effects of nontraditional executive stock option plans," Journal of Financial Economics, Elsevier, vol. 57(1), pages 3-34, July.
- Brian J. Hall & Kevin J. Murphy, 2000.
"Stock Options for Undiversified Executives,"
NBER Working Papers
8052, National Bureau of Economic Research, Inc.
- Han Bleichrodt & Jose Luis Pinto, 2000. "A Parameter-Free Elicitation of the Probability Weighting Function in Medical Decision Analysis," Management Science, INFORMS, vol. 46(11), pages 1485-1496, November.
- Vicky Henderson, 2005. "The impact of the market portfolio on the valuation, incentives and optimality of executive stock options," Quantitative Finance, Taylor & Francis Journals, vol. 5(1), pages 35-47.
- 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.
- Huddart, Steven & Lang, Mark, 1996. "Employee stock option exercises an empirical analysis," Journal of Accounting and Economics, Elsevier, vol. 21(1), pages 5-43, February.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (CCSD).
If references are entirely missing, you can add them using this form.