Cumulative Prospect Theory, Employee Exercise Behaviour and Stock Options Cost Assessment

Abstract

It is well documented in the empirical literature that employee stock options exercise behavior is driven by economic/rational factors as well as by psychological/behavioral factors. The latter include a set of behavioral biases affecting attitudes towards risk. Perhaps the most comprehensive theory that captures these patterns is the Cumulative Prospect Theory (CPT). The central question examined in this paper is whether or not the CPT leads to better predictions of exercise decisions. Using a distorted lattice approach I show that the CPT broadly outperforms in explaining empirical exercise behavior. Interestingly, my empirical estimates of probability weighting are consistent with those from the experimental literature. I argue that this analysis provides a unifying stream for thinking about issues related to stock options exercise and valuation.