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Probability Weighting and Employee Stock Options

Published online by Cambridge University Press:  06 August 2013

Oliver G. Spalt
Oliver G. Spalt*
Affiliation:
o.g.spalt@uvt.nl, School of Economics and Management, Tilburg University, PO Box 90163, Tilburg 5000 LE, The Netherlands.
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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 which 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.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 48 , Issue 4 , August 2013 , pp. 1085 - 1118
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2013 

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