Subjective stock option valuation and the Black-Scholes pricing formula: Empirical evidence of divergence
By R. Michael Holmes Jr, Cynthia E. Devers, Robert M Wiseman
In Press
Academy of Management Journal
Abstract
Assuming a positive influence of stock price volatility on stock option value, incentive alignment proponents argue that stock option compensation encourages managerial risk seeking and, thus, aligns managers’ and shareholders’ risk preferences. Our findings show that holders endow the value from awarded unexercisable stock options such that they over-value held options relative to options being offered and, more importantly, to the value assigned by normative models of stock option valuation (e.g., the Black-Scholes). Further, when valuing unexercisable stock options, the influence of stock price volatility on holders’ subjective valuations is dependent on stock price trend. In sum, these results suggest that during stock option valuation, managers draw on heuristics that financial options theory and models fail to capture. The importance of these findings and their implications for compensation design and research are discussed.
Keywords
Compensation, Decision-Making, Prospect Theory, Stock Option