The Incentives of Equity-Based Compensation and Wealth

This study estimates chief executive officers’ (CEO) subjective valuation of their equity holdings using their revealed preferences conveyed by their decisions to hold or exercise their stock options and to hold or sell their equity shares. Using a random utility framework, I find that the subjective value of equity holdings is associated with both economic and behavioral factors, and that the impact of these factors varies considerably across CEOs. In addition, I find that most CEOs value their equity holdings below the corresponding risk-neutral value, which provides new insight relative to prior literature that examines how insiders value equity-based compensation. This study also provides preliminary evidence regarding the relationship between the sensitivity of CEOs’ subjective value of their equity holdings to changes in stock price (subjective delta) and volatility (subjective vega) and future operating performance, investment and financial risk, and stock price performance. The results frequently diverge from those of prior studies that examine the relationship between risk-neutral equity portfolio deltas and these future performance measures. Collectively, the results of this study highlight the complexity of measuring the equity incentives construct and suggest that an executive’s subjective valuation of equity is a critical component. I acknowledge helpful feedback from my dissertation committee: George Foster (co-chair), Alan Jagolinzer, David Larcker (co-chair), and Madhav Rajan. I also thank Snehal Banerjee, James Early, Ian Gow, Ilan Guttman, Scott Joslin, Ken Judd, Yaniv Konchitchki, Richard Price, Stefan Reichelstein, Peter Reiss, Che-Lin Su, and Taylan Yildiz for their insight. Finally, I am indebted to Kenneth Train for sharing his expertise regarding mixture models of discrete choice.