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Stock options, once exclusive to executives, are now becoming more broad based to include middle management and non‐management employees. In 2000 an estimated 10 million workers’ compensation packages contained stock options. In today’s competitive environment, firms are looking for ways to attract and retain workers, reward outstanding performance, and return value to shareholders while minimising costs. Stock options provide such a vehicle. The paradox is that while stock options are intended to tie pay to performance, many employees lack the knowledge of how the options actually work. Employees need to be educated as to the different types of plans and how it affects their total compensation. A contentious debate exists over whether firms actually benefit from stock options plans and the reasons why some prosper while others fail. Researchers and experts agree that the success of a stock option plan lies largely in how effective firms are at managing the plan and communicating it to its employees.

The objective of this research is to present a causal model of the influence of stock options on psychological contract and employee attitudes, and report results of an initial empirical examination of this model.

To test the model, data were collected using a survey methodology from 98 employees in a large financial services firm. Multiple‐regression equations were used to derive the path coefficients.

The psychological contract variable of met expectations mediated the relationships between stock options and tenure intent and organizational commitment thus providing support for the intrinsic value model. Equity perceptions mediated the relationship between stocks exercised and met expectations. Equity perceptions, however, did not mediate the relationship between stock options and employee attitudes. Similarly, stock earnings also had a direct effect on external career intent indicating that employees who had exercised their stock options were looking for outside career opportunities contrary to our hypothesis.

Future studies should attempt to reconcile the intrinsic versus extrinsic value stock options may have on employee attitudes. These results should be considered tentative and interpreted with caution due to the cross‐sectional nature of data. The support for the intrinsic model suggests that organizations that use stock options may expect positive attitudes from their employees.

This is believed to be the first study that attempts to develop and test a causal model.

This paper looks at the research to date on the future of broadly granted stock options (options granted to at least half the full-time employees of a company). In the U.S., granting options broadly became popular in the late 1990s, but has lost some of its appeal in the wake of stock market declines, accounting changes, and increased shareholder concerns about dilution. The data indicate a significant minority of companies will change their plans, but a substantial majority will keep them. The data also indicate changes in accounting rules will not affect stock prices and that broadly granted options are better for corporate performance than narrowly granted options.

Stock ownership and incentive options are used by companies to retain and motivate employees and managers. These grants usually come with vesting features which require grantees to hold the assets for certain periods. This vesting requirement makes the grantee's total wealth highly undiversified. As a result, as shown by previous researchers, grantees tend to value these incentive securities below market. In this case, grantees will have a strong desire to hedge away the firm-specific risk. Facing the restrictions of direct hedges such as shorting the firm's stock, employees may implement a partial hedge by taking positions in an asset highly correlated with the firm's stock, such as an industry index. In this chapter, we investigate the effects of such a partial hedge. Using the continuous-time, consumption-portfolio framework as a backdrop, we demonstrate that the hedging index can enhance the employee's optimal portfolio holding and increase his intertemporal utility. Consequently, his private valuations of these grants are higher than that without the partial hedging. However, because the partial hedge makes the employee's total wealth less sensitive to the firm's stock price, it will also undermine the incentive effects. Therefore, the presumed incentive effects of these restricted assets should not be taken for granted.

Firms grant non‐tradable stock options to their employees as an incentive device. Is the cost of issuing these options equal to the amount the company would receive if it sold the same options to outside investors? The evaluation of this cost is the main objective of this article. The options granted to employees are not tradable, due to the incentive scheme to which they are related. A non‐tradable option is an asset that cannot be evaluated with standard Black‐Scholes formulas.

The article adopts standard option pricing, introducing some corrections since Black‐Scholes formulae do not apply. The new formulae show the dependence of option values on how diversified both the employees and the firm are; and the influence that the incentive to work by employees has on the stock price.

Once stock options satisfy a participation constraint, they can be granted to employees who stand to gain. However, they do not provide a net benefit in all circumstances to shareholders since they may gain, break even, or lose. Even though in many cases stock options may appear to be an inefficient way to stimulate work effort, in start‐ups and entrepreneurial firms they turn out to be quite beneficial.

Stock option opportunity costs have to be valued taking into account the extent of their non‐tradability and the incentive they provide to employees.

The article introduces a correction for valuing non‐tradable stock options. This permits us to measure properly the opportunity cost of stock options, which is often mis‐specified.

This paper aims to analyze the valuation of stock options from the perspective of an employee exhibiting preferences as described by cumulative prospect theory (CPT). In addition, it elaborates on their incentives effect and some implications in terms of design aspects.

The paper draws on the CPT framework to derive a continuous time model of the stock option subjective value using the certainty equivalence principle. Numerical simulations are used in order to analyze the subjective value sensitivity with respect to preferences‐related parameters and to investigate the incentives effect.

Consistent with a growing body of empirical and experimental studies, the model predicts that the employee may overestimate the value of his options in‐excess of their risk‐neutral value. Moreover, for typical setting of preferences parameters around the experimental estimates, and assuming the company is allowed to adjust existing compensation when making new stock option grants, the model predicts that incentives are maximized for strike prices set around the stock price at inception. This finding is consistent with companies’ actual compensation practices. Finally, the model predicts that an executive who is subject to probability weighting may be more prompted than a risk‐neutral executive to act in order to increase the firm's assets volatility.

This research proposes an alternative theoretical framework for the analysis of pay‐to‐performance sensitivity of equity‐based compensation that takes into account a number of prominent patterns of employee behavior that expected utility theory cannot explain. It contributes to recent empirical and theoretical researches that have advanced CPT framework as a promising candidate for the analysis of equity‐based compensation contracts.

This paper aims to derive firm value implications for various kinds of employee stock options (ESOs) in a framework that considers uncertainty, non‐diversification and the US statutory tax treatment.

The authors extend the analysis of ESOs from the case of perfect capital markets to two cases of imperfect capital markets using the Benninga‐Helmantel‐Sarig framework.

It is found that ESOs are inferior to cash compensation and that the degree of option inferiority depends on employee diversification. In addition, incentive stock options (ISOs) are generally inferior to non‐qualified stock options (NSOs). This relative profitability of the NSO versus ISO increases as market imperfections are added. The authors also find that in general firm hedging of ESOs is suboptimal.

The paper highlights the firm value of employee stock options.

From 2007, New Zealand firms must report the cost of granting employee stock options (ESOs). Market‐based option pricing models assume that option holders are unconstrained in their portfolio choices and thus are indifferent to the specific risk of any firm. By contrast, ESO holders are frequently required to hold portfolios that are over‐exposed to the firm that employs them and so adopt exercise policies that reflect their individual risk preferences. Applying the model of Ingersoll (2006) to hypothetical ESOs, we show that ESO cost can be extremely sensitive to employee characteristics of risk aversion and under‐diversification. This result casts doubt on the usefulness of any market‐based model for pricing ESOs, since such models, by definition, produce option values that are independent of employee characteristics. By limiting employee discretion over the choice of exercise date, vesting restrictions help reduce the magnitude of this problem.

This paper analyzes economic, legal, behavioral and public policy issues pertaining to the accounting for employee stock options. The paper explains why employee stock options (ESOs) are superior to other forms of incentive compensation, why ESOs in their present form are inefficient and why particular accounting, legal and tax treatments will provide the optimal results for the economy, the government, management/employees and shareholders. The issues discussed in this article are relevant in ESO accounting, regulation of ESOs, incentive compensation, human resources analysis, tax policy, corporate governance, fraud, valuation of companies, derivatives regulation, behavioral analysis of law/rules, portfolio management and management strategy.