Probability Weighting and Employee Stock Options

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

See all articles by Oliver G. Spalt

Oliver G. Spalt

University of Mannheim - Business School; European Corporate Governance Institute (ECGI)

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)

University of Mannheim - Business School ( email )

L5, 5
Mannheim, 68131
Germany

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

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