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Executive Stock Options when Managers are Loss-Averse

  • Dittmann, Ingolf

    (Erasmus School of Economics Rotterdam)

  • Maug, Ernst

    (Chair for Corporate Finance, University of Mannheim and Sonderforschungsbereich 504)

  • Spalt, Oliver

    (Chair for Corporate Finance, University of Mannheim and Sonderforschungsbereich 504)

This paper analyzes optimal executive compensation contracts when managers are loss averse. We establish the general optimal contract analytically and parameterize the model using data on compensation contracts for 595 CEOs. Parameters for preferences are based on the experimental literature. Overall, the Loss Aversion-model dominates an equivalent Risk Aversion-model, especially with respect to its ability to predict options as part of the optimal contract. The Loss Aversion-model performs well in terms of predicting observed compensation contracts if the reference wage is assumed to lie not too far above previous year’s fixed wage. Our results suggest that loss aversion is a better paradigm for analyzing design features of stock options and for developing preference-based valuation models than the conventional model used in the literature.

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Paper provided by Sonderforschungsbereich 504, Universität Mannheim & Sonderforschungsbereich 504, University of Mannheim in its series Sonderforschungsbereich 504 Publications with number 07-36.

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Length: 51 pages
Date of creation: 26 Jun 2007
Date of revision:
Handle: RePEc:xrs:sfbmaa:07-36
Note: Financial support from the Deutsche Forschungsgemeinschaft, SFB 504, at the University of Mannheim, is gratefully acknowledged.
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