The Effects of Endowment and Loss Aversion in Managerial Stock Option Valuation

Abstract

Assuming a positive influence of stock price volatility on stock option value, incentive alignment proponents argue that stock option compensation encourages managerial risk seeking and, thus, aligns managers' and shareholders' risk preferences. Our findings show that stock option holders overvalue unexercisable options relative to options being offered and to normative (e.g., Black-Scholes) valuations. Further, the influence of stock price volatility on holders' subjective valuations depends on stock price trend. In sum, results suggest that during stock option valuation, managers draw on heuristics that financial options theory and models fail to capture. We discuss implications for compensation design and research.

Keywords: stock options, executive compensation, agency theory, black-scholes, behavioral theory