Employee Stock Options Incentive Effects: A CPT-Based Model

12 Pages Posted: 16 May 2011 Last revised: 12 Jun 2012

See all articles by Hamza Bahaji

Hamza Bahaji

University of Paris 9 Dauphine, DRM-Finance; NATIXIS Asset Management

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Date Written: April 1, 2010

Abstract

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 risk-averse 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.

Keywords: Stock options, Cumulative Prospect Theory, Incentives, Subjective value

JEL Classification: J33, J44, G13, G32, M12

Suggested Citation

Bahaji, Hamza, Employee Stock Options Incentive Effects: A CPT-Based Model (April 1, 2010). 8th AFE SAMAOS 2011. Available at SSRN: https://ssrn.com/abstract=1833414 or http://dx.doi.org/10.2139/ssrn.1833414

Hamza Bahaji (Contact Author)

University of Paris 9 Dauphine, DRM-Finance ( email )

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Paris, 75775
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00 33 6 10 30 03 67 (Phone)

NATIXIS Asset Management ( email )

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