The Impact of Risk and Sentiment on Executive Stock Options

Abstract

This study provides model-based and compensation-based approaches to price subjective value of employee stock options (ESOs). Option pricing models accounting for illiquidity generally imply the options are valued at a discount to the Black-Scholes value. Our model considers the role of sentiment, which offsets illiquidity. Using executive stock options and compensation data from 1992 to 2004 for S&P 1500 firms, we find that executives value ESOs at a 48% premium to the Black-Scholes value. These premia are explained by a sentiment level of 12% in risk-adjusted, annualized return, suggesting a high level of executive overconfidence. Subjective value relates negatively to illiquidity and idiosyncratic risk, and positively to sentiment in all specifications, consistent with the offsetting roles of sentiment and risk aversion. ?