Experimental test of subjective valuations

Abstract

Conducting an experiment at this stage serves a number of purposes. In this book several things have already been accomplished. First, a conceptual model of how executives may value their stock option grants was developed. This model contains a certainty equivalent procedure, using approximations for the individual’s risk aversion and framing of events, as well as the influence of subjective decision weighting. Next, the model was operationally implemented which made it possible to study the role of certain parameters on the valuation. In particular, the influence of the exercise price on the value gap and pay-performance intensity was assessed. Finally, some first conclusions have been put forward. One of the main hypotheses, that spring from the theoretical model, is that stock options may, in fact, be an efficient form of compensation, as executives actually overvalue them as long as the exercise price is not set too high. For example, a stock option with an exercise price around the current market value at the time of grant would attract a premium subjective valuation. This finding deviates significantly from previous models. The reason for the difference is that in the proposed new model the assumed decision weighting process compensates for the effects of risk aversion. As a result, the value gap is reduced or can even turn into a value premium. Next, the model suggests that to maximise pay-performance intensity and pay-volatility intensity a high exercise price is advisable.