Employee Stock Option-Implied Risk Attitude Under Rank-Dependent Expected Utility
30 Pages Posted: 4 Oct 2014 Last revised: 20 Dec 2015
Date Written: August 2, 2013
Probability weighting is one of the cornerstones of decision-making theories accommodating gambling preferences. This paper examines its relevance to explaining employee stock option exercise behavior. We characterized the optimal exercise policy for a representative employee with Rank-Dependent Expected Utility (RDEU) preferences. We find that the RDEU framework leads to improved predictions of empirical exercise patterns. The implications from our findings are twofold: (1) probability weighting implies an increase in stock option cost to shareholders; (2) employee exercise behavior-implied sentiment is affected by the firm’s stock market risk and performance.
Keywords: Stock options, Exercise behavior, Probability weighting, Employee sentiment
JEL Classification: G13, G30, J33, M41
Suggested Citation: Suggested Citation