Probability Weighting and Employee Stock Options

This paper documents that riskier firms grant more stock options to non-executive employees using a large panel of US firms from 1992 to 2005. A simple model in which a risk-neutral firm and an employee with cumulative prospect theory preferences bargain over the employee’s pay package can provide an explanation for this otherwise puzzling behavior. The key feature which makes stock options attractive is the well-established tendency of individuals to overweight small probabilities of large gains. I calibrate the model using standard parameters from the experimental literature and find that it fits the data remarkably well. In addition, I show that probability weighting, when combined with the assumption of myopic employees, generates predictions that are quantitatively consistent with observed patterns of stock option exercises.