EMPLOYEE STOCK OPTIONS INCENTIVE EFFECTS: A CPT-BASED MODEL

Hamza Bahaji ()
Additional contact information
Hamza Bahaji: DRM - Dauphine Recherches en Management - Université Paris Dauphine-PSL - PSL - Université Paris Sciences et Lettres - CNRS - Centre National de la Recherche Scientifique

Working Papers from HAL

Abstract: 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 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.

Keywords: Stock options; Cumulative Prospect Theory; Incentives; Subjective value (search for similar items in EconPapers)
Date: 2011-04-01
New Economics Papers: this item is included in nep-upt
Note: View the original document on HAL open archive server: https://shs.hal.science/halshs-00618477v1
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
https://shs.hal.science/halshs-00618477v1/document (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:hal:wpaper:halshs-00618477

Access Statistics for this paper

More papers in Working Papers from HAL
Bibliographic data for series maintained by CCSD ().