Stock options under non- expected utility theory

This paper modifies the modeling approach of Lambert et al. (1991) and Hall and Murphy (2000, 2002) to assess the value of executive stock options in the presence of deviations from expected utility maximization. In particular, we specify a valuation model which incorporates elements of cumulative prospect theory. We conclude that this could potentially close the value gap identified by Lambert et al. (2002) and Hall and Murphy (2000, 2002) that results from risk aversion of executives who get part of their compensation in the form of stock options and are not able to hold sufficiently diversified portfolios. Moreover, introducing probability weighting also affects executives’ willingness to take on risky investment projects. These findings are confirmed in an experiment.

[1]  J. Hull,et al.  How to Value Employee Stock Options , 2004 .

[2]  M. Degroot,et al.  Measuring utility by a single-response sequential method. , 1964, Behavioral science.

[3]  E. Rowland.  Theory of Games and Economic Behavior , 1946, Nature.

[4]  J. Quiggin.  A theory of anticipated utility , 1982 .

[5]  J. Carpenter,et al.  The Exercise and Valuation of Executive Stock Options , 1997 .

[6]  Mark Rubinstein,et al.  On the Accounting Valuation of Employee Stock Options , 1995 .

[7]  J. Kagel,et al.  Handbook of Experimental Economics , 1997 .

[8]  M. C. Jensen,et al.  Harvard Business School; SSRN; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI); Harvard University - Accounting & Control Unit , 1976 .

[9]  Markus Glaser,et al.  What Determines How Top Managers Value Their Stock Options? , 2010 .

[10]  Ulrike Malmendier,et al.  Corporate Financial Policies with Overconfident Managers , 2005 .

[11]  A. Tversky,et al.  Prospect theory: an analysis of decision under risk — Source link , 2007 .

[12]  Chip Heath,et al.  Psychological Factors and Stock Option Exercise , 1998 .

[13]  Kevin J. Murphy,et al.  Stock Options for Undiversified Executives , 2000 .

[14]  Arjan Berkelaar,et al.  Optimal Portfolio Choice under Loss Aversion , 2000, Review of Economics and Statistics.

[15]  Terrance Odean,et al.  Are Investors Reluctant to Realize Their Losses? , 1996 .

[16]  John M. Barron,et al.  Executive compensation. , 1990, Trustee : the journal for hospital governing boards.

[17]  Johnathan Mun,et al.  Valuing Employee Stock Options , 2004 .

[18]  L. Meulbroek,et al.  The Efficiency of Equity-Linked Compensation: Understanding the Full Cost of Awarding Executive Stock Options , 2000 .

[19]  R. Lambert,et al.  PORTFOLIO CONSIDERATIONS IN VALUING EXECUTIVE-COMPENSATION , 1991 .

[20]  M. Abdellaoui.  Parameter-Free Elicitation of Utility and Probability Weighting Functions , 2000 .

[21]  N. Weinstein.  Unrealistic optimism about future life events , 1980 .

[22]  D. Wehrung.  Risk taking over gains and losses: A study of oil executives , 1989 .

[23]  A. Tversky,et al.  Prospect Theory : An Analysis of Decision under Risk Author ( s ) : , 2007 .

[24]  A. Tversky,et al.  Advances in prospect theory: Cumulative representation of uncertainty , 1992 .

[25]  Richard Gonzalez,et al.  On the Shape of the Probability Weighting Function , 1999, Cognitive Psychology.

[26]  Gerald A. Feltham,et al.  Incentive Efficiency of Stock versus Options , 2001 .

[27]  Ulrike Malmendier,et al.  CEO Overconfidence and Corporate Investment , 2002 .

[28]  D. Kahneman,et al.  Timid choices and bold forecasts: a cognitive perspective on risk taking , 1993 .

[29]  D. Hirshleifer.  Investor Psychology and Asset Pricing , 2001 .

[30]  Michael L. Lemmon,et al.  Exercise behavior, valuation, and the incentive effects of employee stock options , 2005 .

[31]  Martin Weber,et al.  What Determines the Shape of the Probability Weighting Function Under Uncertainty? , 1998, Manag. Sci..

[32]  D. Reitman.  Stock Options and the Strategic Use of Managerial Incentives , 1993 .

[33]  N. Barberis,et al.  What Drives the Disposition Effect? An Analysis of a Long-Standing Preference-Based Explanation , 2006 .

[34]  A. Tversky,et al.  The framing of decisions and the psychology of choice. , 1981, Science.

[35]  W. Sharpe.  CAPITAL ASSET PRICES: A THEORY OF MARKET EQUILIBRIUM UNDER CONDITIONS OF RISK* , 1964 .

[36]  Kevin J. Murphy,et al.  CEO Incentives—It's Not How Much You Pay, But How* , 1990 .

[37]  D. Larcker,et al.  Executive Equity Compensation and Incentives: A Survey , 2002 .

[38]  Lemma W. Senbet,et al.  Resolving the Agency Problems of External Capital through Options , 1981 .

[39]  Martin Weber,et al.  The impact of endowment framing on market prices -- an experimental analysis , 2000 .

[40]  J. March,et al.  Managerial perspectives on risk and risk taking , 1987 .

[41]  F. Black,et al.  The Pricing of Options and Corporate Liabilities , 1973, Journal of Political Economy.

[42]  Brad M. Barber,et al.  The Courage of Misguided Convictions: The Trading Behavior of Individual Investors , 2000 .

[43]  S. Ross,et al.  Option pricing: A simplified approach☆ , 1979 .

[44]  Stuart L. Gillan.  Option-Based Compensation: Panacea or Pandora's Box? , 2001 .

[45]  Martin Weber,et al.  How Do Managers Behave in Stock Option Plans? Clinical Evidence from Exercise and Survey Data , 2008 .