ESO Compensation: The Roles of Default Risk and Over-Confidence

40 Pages Posted: 15 Jun 2006

See all articles by Charles Chang

Charles Chang

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF)

Cheng-der Fuh

Academia Sinica

Kate Hsu

University of Illinois at Urbana-Champaign

Date Written: June 12, 2006

Abstract

We derive a pricing model for employee stock options (ESO) that expands on Ingersoll (2006) by including default risk and that additionally considers the effects of employee over-confidence. We find that illiquidity reduces subjective value and alters incentive effects and value sensitivities. The ESO discount is increasing in risk-aversion and decreasing in tradability, but may be offset by employee over-confidence. Under normal calibrations, subjective value is approximately 40% less than market value, but employees who over-estimate firm returns by more than 5% value ESOs higher than the market. Our results potentially impact ESO accounting regulations as well as compensation decisions.

Keywords: stock options, over-confidence, default model, jump diffusion

JEL Classification: G11, G13, G32, G35, J33, M41, M44

Suggested Citation

Chang, Charles and Fuh, Cheng-der and Hsu, Kate, ESO Compensation: The Roles of Default Risk and Over-Confidence (June 12, 2006). Available at SSRN: https://ssrn.com/abstract=908591 or http://dx.doi.org/10.2139/ssrn.908591

Charles Chang (Contact Author)

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

Cheng-der Fuh

Academia Sinica ( email )

Nankang
Taipei, 11529
Taiwan

Kate Hsu

University of Illinois at Urbana-Champaign ( email )

601 E John St
Champaign, IL 61820
United States

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