Probability Weighting and Employee Stock Options

Abstract

This paper documents that riskier firms with higher idiosyncratic volatility grant more stock options to nonexecutive employees. Standard models in the literature cannot easily explain this pattern; a model in which a risk-neutral firm and an employee with prospect theory preferences bargain over the employee's pay package can. The key feature that makes stock options attractive is probability weighting. The model fits the data on option grants well when calibrated using standard parameters from the experimental literature. The results are the first evidence that risky firms can profitably use stock options to cater to an employee demand for long-shot bets. * Spalt, o.g.spalt@uvt.nl,

Thirty Years of Prospect Theory in Economics: A Review and Assessment

“…Insights from these papers can when the agent has prospect theory preferences. Insights from these papers can help explain the prevalence of stock help explain the prevalence of stock options, rather than just stock, in the compensa-, rather than just stock, in the compensation packages of both executive and nonexecutive employees (Dittman, Maug, and tion packages of both executive and nonexecutive employees (Dittman, Maug, and Spalt 2010;Spalt forthcoming). Spalt 2010; Spalt forthcoming).…”

Thirty Years of Prospect Theory in Economics: A Review and Assessment

“…Some recent papers study contracting between a principal and an agent when the agent has prospect theory preferences. Insights from these papers can help explain the prevalence of stock options, rather than just stock, in the compensation packages of both executive and non-executive employees (Dittman, Maug, and Spalt 2010;Spalt forthcoming).…”

A Model of Equity Based Compensation with Tax

“…However, the risk aversion framework is not consistent with the empirical fact that a large number of options is granted to lower level employees. Solutions to this inconsistency are to assume employees are loss averse (see Dittmann et al., ), have prospect theory preferences (see Spalt, ), or are overconfident (Oyer and Schaefer, ). These single period model results generate scenarios in which options are preferred to other forms of compensation.…”

“…First, stock options have become an important instrument for rewarding all levels of employees in recent years, but no agreement has been reached as to why granting options is such a popular practice. Economic theories propose some possible explanations: providing incentive to executives (Hall and Murphy, ), providing non‐debt tax shield (Graham, ), employee optimism (Oyer and Schaefer, ), employee retention (Oyer, ), and employee preferences (Dittmann et al., ; Spalt, ) but none of these explanations can single‐handedly explain the wide popularity of broad‐based option plans. Our study provides evidence that the optimal compensation package is tax dependent, for example when considering the US and UK, different compensation packages are preferred purely as a result of different tax rules.…”