The Effect of Executive Confidence, Ability, and Private Beliefs on the Valuation of Executive Stock Options

Abstract

It is widely believed that executives value stock options at considerably less than market or Black-Scholes-Merton values. This belief is contingent, however, on a subtle assumption that executives are like price-taking shareholders. We argue that executives not only have ability to influence the stock but are also confident and optimistic, leading them to a private valuation of the stock that exceeds the market value. Hence, executives value their options at more than would be obtained by traditional executive stock option valuation models. In some cases, these options are worth even more than the values of analogous publicly traded options. We also find that consideration of these effects can alter early exercise behavior, leading executives who perceive themselves to be better to exercise at higher prices. Our results contrast with the existing body of literature that values stock options as though executives were simply ordinary investors with poorly diversified portfolios.