Penn State University - Smeal College of Business
PSU search
Student Exchange Smeal site map Contact us Accounting faculty directory

Steven Huddart picture
 
Should I exercise my stock options?
 
 
Research
 
Case Studies
 
Courses
 
 
Stock compensation glossary
 
Compensation links
 
Securities law links
 
Tax links
 
 
Office hours and location
 
Facts About The School
 
Home | Previous | Next | Huddart Site Map

Risk aversion


To illustrate the concept of risk aversion in the context of options, imagine a fair coin will be tossed a year from now. If the coin comes up heads, you will receive $1 million. If the coin comes up tails, you receive nothing. Note that the coin toss is a kind of option. The expected value of the payment you will receive in one year is $500,000, which is half of $1 million. If the discount rate is 11% per year, the present value of the expected payment in one year is $450,450, which is $500,000 divided by 1.11. The amount $450,450 is the fair value of the right to receive either $1,000,000 or zero in one year depending on the outcome of the coin toss. That is, it is the Fair value of the option. A risk-neutral entity is indifferent between $450,450 and the option. A risk-averse individual strictly prefers a sure payment today of $450,450 to the right to receive either $1,000,000 or zero in one year depending on the outcome of the coin toss. In other words, a risk-averse individual would willingly exchange the option for a cash payment of less than $450,450.

Individuals typically are risk-averse. Entities such as corporations that pool the financial interests of many shareholders are typically thought to be nearly risk-neutral. Thus, it is entirely consistent that the cost of the option to the corporation, which the Financial Accounting Standards Board labels the option's fair value, exceeds the cash payment the employee would willingly accept in exchange for the option.


Steven Huddart
Smeal College of Business, Penn State University, University Park, PA 16802-3603 USA
(814) 863-0048
huddart@psu.edu
vCard
Home | Previous | Next | Huddart Site Map

http://personal.psu.edu/sjh11/OptionGlossary/RiskAversion.shtml
was last updated on Tue, Aug 21, 2018.
Today is Sun, Sep 15, 2019.

Unless otherwise noted, all material is:
Copyright ©1995-2018 Steven Huddart. All rights reserved.