Why do employees like to be paid with Options? A multi-period prospect theory approach

Research output: Contribution to journalArticlepeer-review

Abstract

The use of options as compensation for non-executive employees is a puzzle. Standard, rational, valuation models show that the cost of issuing options is larger than the value placed on the options by employees. Existing explanations for this puzzle are based upon static models that ignore the considerable dynamic aspects of employee stock option pricing and exercise behavior. We develop dynamic, multiperiod models of employee preferences considering risk aversion, loss aversion, overconfidence and probability weighting to test possible explanations of the use of employee stock options. We find that a cumulative prospect theory model generates scenarios where employees would prefer options to either cash or equity payments, and also optimally exercise their options early. This is the only model where options are preferred and also optimally exercised early.

Original languageEnglish (US)
Pages (from-to)106-125
Number of pages20
JournalJournal of Corporate Finance
Volume38
DOIs
StatePublished - Jun 1 2016

Keywords

  • Early exercise
  • Employee stock options
  • Overconfidence
  • Prospect theory

ASJC Scopus subject areas

  • Business and International Management
  • Finance
  • Economics and Econometrics
  • Strategy and Management

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