Probability Weighting and Employee Stock Options

Abstract:     
This paper documents that riskier firms, in particular firms with higher idiosyncratic volatility, grant more stock options to non-executive employees. Standard models in the literature cannot easily explain this pattern. A simple model in which a risk-neutral firm and an employee with cumulative prospect theory preferences bargain over the employee's pay package can. The key feature which makes stock options attractive is probability weighting. The model fits the data on option grants remarkably well when calibrated using standard parameters from the experimental literature. Overall, the results suggest that risky firms can profitably use stock options to cater to an employee demand for long-shot bets.

Number of Pages in PDF File: 46

Keywords: Behavioral Corporate Finance, Cumulative prospect theory, Employee stock options

JEL Classification: G30, J33, M52

Accepted Paper Series