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Executive Stock Options when Managers are Loss-Averse

Ingolf Dittmann, Ernst Maug and Oliver Spalt
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Ernst Maug: Chair for Corporate Finance, University of Mannheim and Sonderforschungsbereich 504, Postal: L9, 1-2, 68131 Mannheim
Oliver Spalt: Chair for Corporate Finance, University of Mannheim and Sonderforschungsbereich 504, Postal: L9, 1-2, 68131 Mannheim

No 07-36, Sonderforschungsbereich 504 Publications from Sonderforschungsbereich 504, Universität Mannheim, Sonderforschungsbereich 504, University of Mannheim

Abstract: 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.

Pages: 51 pages
Date: 2007-06-26
New Economics Papers: this item is included in nep-bec, nep-cfn, nep-cta, nep-lab and nep-upt
Note: Financial support from the Deutsche Forschungsgemeinschaft, SFB 504, at the University of Mannheim, is gratefully acknowledged.
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