This research provides an alternative framework for the valuation of standard employee stock options and for the analysis of exercise behavior patterns. It develops a binomial model where the exercise decision obeys to a policy that maximizes the expected utility to a representative employee exhibiting preferences as described by the Cumulative Prospect Theory (CPT). This model also accounts for exogenous non-market factors that may cause early exercise. Using a large database on stock options exercise transactions in 12 US public corporations, we examined the performance of our model in predicting actual exercise patterns. Interestingly, the model calibrations yield probability weighting coefficient estimates that are consistent with the estimates from the experimental literature. Further, our results suggest that the CPT-based model outperforms the Expected Utility Theory-based model in predicting actual exercise patterns in our sample. These findings convey the main contribution of this paper which is the strong ability of the CPT framework to explain the employees exercise behavior. It therefore provides rationale for using this framework in order to get more accurate fair value estimates of employee stock options contracts.
