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Probability Weighting and Employee Stock Options

46 Pages Posted: 9 Mar 2008 Last revised: 3 Apr 2012

Oliver G. Spalt

Tilburg University - Department of Finance

Date Written: April 13, 2011

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.

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

JEL Classification: G30, J33, M52

Suggested Citation

Spalt, Oliver G., Probability Weighting and Employee Stock Options (April 13, 2011). AFA 2009 San Francisco Meetings Paper; Journal of Financial and Quantitative Analysis (JFQA), Forthcoming. Available at SSRN: https://ssrn.com/abstract=1102947 or http://dx.doi.org/10.2139/ssrn.1102947

Oliver G. Spalt (Contact Author)

Tilburg University - Department of Finance ( email )

Department of Finance
Tilburg University
Tilburg, 5000 LE
Netherlands
+31 13 466 3545 (Phone)

HOME PAGE: http://www.oliverspalt.com

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