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Employee Stock Options Incentive Effects: A CPT-Based Model

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DOC170412.pdf (571.8Kb)
Date
2011
Dewey
Economie financière
Sujet
Stock-options; Cumulative Prospect Theory; Incentives; Subjective value
JEL code
J33; J44; G13; G32; M12
Conference name
8th International Conference on Applied Financial Economics
Conference date
06-2011
Conference city
Samos
Conference country
Grèce
Book title
Proceedings of the 8th International Conference on Applied Financial Economics - Vol A
Author
Prachalias, Chrysovaladis
Publisher
National and Kapodistrian University of Athens
Publisher city
Athènes
Year
2011
Pages number
600
ISBN
978-960-466-085-8
URI
https://basepub.dauphine.fr/handle/123456789/8915
Collections
  • DRM : Publications
Metadata
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Author
Bahaji, Hamza
Type
Communication / Conférence
Item number of pages
499-508
Abstract (EN)
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 riskaverse 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.

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