ESO Compensation: The Roles of Default Risk and Over-Confidence

Abstract

We derive a pricing model for employee stock options (ESO) that expands on Ingersoll (2006) by including default risk and that additionally considers the effects of employee over-confidence. We find that illiquidity reduces subjective value and alters incentive effects and value sensitivities. The ESO discount is increasing in risk-aversion and decreasing in tradability, but may be offset by employee over-confidence. Under normal calibrations, subjective value is approximately 40% less than market value, but employees who over-estimate firm returns by more than 5% value ESOs higher than the market. Our results potentially impact ESO accounting regulations as well as compensation decisions.

Keywords: stock options, over-confidence, default model, jump diffusion

JEL Classification: G11, G13, G32, G35, J33, M41, M44