Neglected Risk in Financial Innovation: Evidence from Structured Product Counterparty Exposure

We investigate the compensation of counterparty exposure in the prices of structured products. Our analysis reveals that product issuers did not compensate retail investors for counterparty exposure before the Lehman default. Post-Lehman, retail prices have no longer neglected this risk. We also measure retail investor attention towards issuer credit risk. For a given level of issuer credit risk, counterparty exposure is compensated more when attention is higher. Furthermore, issuers tend to construct products with larger counterparty exposure. Overall, our results shed light on the conditions under which financial engineering generates neglected risk.     

How biased is the behavior of the individual investor in warrants?

Based on the actual trading behavior of individual investors in the Portuguese financial market during almost ten years this paper examines the socio-demographic characteristics of retail investors in warrants, and discusses the hypothesis that some behavioral biases do have an impact on the investors’ predisposition to invest and trade in warrants, a complex financial instrument. One finds that there is a profile of investors in warrants: younger and less educated men are more likely to invest in warrants and that overconfident, disposition-prone and investors exhibiting a gambling attitude are more likely to invest and trade in warrants. Secondly, the gambling motive seems to be a distinguishing characteristic of investors in warrants. In other words, when investors are driven to trade in financial markets for pleasure/fun they tend to trade complex products more and to trade simple and easier to understand financial instruments less. Finally, the higher the intensity of trading the more relevant are the disposition and the gambler’s biases.     

Financial literacy and portfolio diversification

We use a survey of individual investors disclosed by the Portuguese Securities Commission (CMVM) in May 2005 to study the impact of investors’ levels of financial literacy on portfolio diversification. We consider distinct aspects of financial literacy, and control for socioeconomic and behavioral differences among individual groups of investors. Our results suggest that investors’ educational levels and their financial knowledge have a positive impact on investor diversification. The information sources used by retail investors to gather information on markets and financial products also have a significant impact on the number of different assets included in a portfolio.     

The role of creative strategy,ad disclosure and regulatory focus in investors’ decision making: An experimental investigation

This study examines the effects of creative strategy and ad disclosure in financial services advertising (FSA) and individual differences in regulatory focus on retail investors’ attitudes and behavioral intentions. Results from a between-subject experiment indicate that investors’ regulatory focus (promotion focus versus prevention focus) moderates the effects of FSA related to creative strategy and ad disclosure. Specifically, prevention-focused investors (promotion-focused investors) had more favorable attitudes towards and showed greater purchase intentions of a financial product when exposed to informational ads and ads with disclosures (transformational ads and ads without disclosures). The authors offer theoretical, managerial and public policy implications.     

Pricing effects when competitors arrive: The case of discount certificates in Germany

This article investigates how overpricing of outstanding certificates, also called master certificates, changes when competing products that duplicate the features of master certificates are issued. I argue that competition effects may be reverted and overpricing may increase rather than decrease after competitors arrive, when retail investors fail to detect implications of credit risk differences on certificates’ values. Using difference-in-differences estimations on matched samples, I find that overpricing of master certificates decreases after the competing products have been issued, but only when the master issuer’s credit risk is lower than that of the duplicate issuer, while it increases when the credit risk difference is positive. These findings are robust to controlling for retail investors’ demand in various ways. Thus, the study indicates that retail investors’ failure to detect the value implications of issuers’ credit risk can undermine product competition.     

Financial Product Design,Retail Investor Sophistication and Issuer Incentives: A Case Study

Many financial products and securities marketed to retail investors involve design features that can make it difficult to understand the risk and return characteristics involved. This paper examines one such security, Convertible Preference Step Up Units (CPUs), issued in Australia by the US Masters Residential Property Fund (URF) at the end of 2017. It argues that an apparently relatively simple design masks significant complexity which would make risk assessment and fair pricing well beyond the capabilities of retail investors. Despite that, analysis of the security design and disclosure documents suggests that it would not fall foul of the financial product banning powers recommended for the Australian Securities and Investment Commission by the 2014 Australian Financial System Inquiry and in draft legislation as at mid 2018. This highlights the difficulties for effective financial consumer protection resulting from the mismatch between financial literacy levels and financial product design.     

Pricing,issuance volume,and design of innovative securities: The role of investor information

This study investigates the role of asymmetric information for the pricing, issuance volume, and design of innovative securities. By analyzing the information that structured product issuers provide to the investors of those products, we can identify specific sources of asymmetric information between the issuers and investors in this market. We show that issuers exploit this information friction to offer products to investors that appear more profitable for the issuer. In addition, we find that the friction induces issuers to design products with higher information asymmetry. Our results suggest that product issuers’ behavior increases information frictions in the financial system.     

Selecting Australian equity superannuation funds: A retail investor's perspective

In this performance persistence study, two questions are addressed. First, what is the relationship between past fund returns and future performance? Secondly, does a ’hot hand‘ fund selection system deliver economically significant returns to investors? Using a sample of Australian equity superannuation funds over the 1990s, the answers from this study are as follows: on a raw and risk-adjusted return basis the authors find evidence of mean reversion, with prior annual performance having little influence on future fund return. Selecting funds based on a persistence strategy resulted in underperformance of industry and passive returns for the retail superannuation investor over the sample period. The findings of the study have serious implications for financial planning advisers who market superannuation funds based on past performance. The results suggest that previous annual performance has little influence on future returns.     

The dark side of financial innovation: A case study of the pricing of a retail financial product

The offering prices of 64 issues of a popular retail structured equity product were, on average, almost 8% greater than estimates of the products' fair market values obtained using option pricing methods. Under reasonable assumptions about the underlying stocks' expected returns, the mean expected return estimate on the structured products is slightly below zero. The products do not provide tax, liquidity, or other benefits, and it is difficult to rationalize their purchase by informed rational investors. Our findings are, however, consistent with the recent hypothesis that issuing firms might shroud some aspects of innovative securities or introduce complexity to exploit uninformed investors.     

Factors affecting investors’ intention to purchase gold and silver bullion: evidence from Malaysia

Gold and silver prices have surged since the 1980s, and they have been used as a store of value for fear of a financial meltdown. However, gold and silver in the form of bullion are still not so popular compared with other gold and silver products (jewellery) and other financial instruments in Malaysia. Limited study has actually verified the factors that affect the investors’ intention to purchase bullion. Thus, this study explores factors affecting investors’ behaviour and their intention to purchase bullion based on the Theory of Planned Behaviour. This study also examines the moderating effect of scepticism between investors’ behaviour and their intention to purchase bullion. A total of 208 sets of data collected in a self-administered online structured survey was analysed using PLS-SEM. This study finds that investors’ behavioural belief and control belief significantly and positively affect their respective attitude towards behaviour and perceived behavioural control and, thus, intention to purchase bullion. Results are found insignificant for normative belief, normative attitude and intention to purchase bullion and the moderating effect of scepticism in affecting investors’ intention to purchase bullion. The findings of this study hope to provide insight and deeper understanding to bullion traders and financial advisors in improving their marketing strategies in growing interest in the bullion market.

     

Credit ratings and structured finance

The poor performance of credit ratings of structured finance products in the financial crisis has prompted investigation into the role of credit rating agencies (CRAs) in designing and marketing these products. We analyze a two-period reputation model in which a CRA both designs and rates securities that are sold both to investors who are constrained to purchase highly rated securities and investors who are unconstrained. Assets are pooled and senior and junior tranches are issued with a waterfall structure. When the rating constraint is lax, the CRA will include only risky assets in the securitization pool, serving both types of investors without any rating inflation. Rating inflation is decreasing in the tightness of the rating constraint locally. But rating inflation may be non-monotonic in the rating constraint globally, with no rating inflation when the constraint is lax or tight.     

Are paper winners gamblers? Evidence from Australian retail investors

This study examines stock market gambling using a comprehensive set of investor characteristics and past portfolio performance measures. We find that retail investors overinvest in ‘lottery stocks’, stocks with gambling‐like properties. Significant portfolio underperformance is the result of gambling through lottery stocks. Investors are more likely to gamble following recent portfolio paper gains, regardless of realised performance, providing new evidence that paper gains trigger a house money effect. Investors trading greater values or holding more stocks, and older and female investors, are less likely to invest in lottery stocks.     

Institutional versus retail trades following financial restatements: The effect of Sarbanes-Oxley

Regulators have expressed concern that the growing number and size of financial restatements, especially since the passage of the Sarbanes-Oxley Act of 2002 (SOX), confuse investors and erode confidence in the capital markets. Given the investor protection goal of SOX, of particular concern is the relative accuracy with which retail investors process and trade on the information contained in restatement announcements. In this paper, we adopt a market based approach and examine the accuracy of the trading behavior of retail and institutional investors conditioned upon accounting restatement announcements, both prior- and subsequent to the passage of SOX. We find that retail investors engaged in more inaccurate (i.e., potentially loss-making) trades in the post-SOX period than in the pre-SOX period. In contrast, the accuracy (i.e., conditional profit potential) of institutional investors’ trades does not show any significant difference between the pre- and post-SOX regimes. Thus, we document that retail (but not institutional) investors processed post-SOX restatements more inaccurately than pre-SOX restatements.     

Deane–Draper stores: employee empowerment in a retail environment

This case focuses on the application of employee empowerment principles to a large retail group. It provides the opportunity to analyse the manner of the strategy implementation and the consequent impact on both individuals and the organization. The case establishes significant financial underperformance in one part of a retail group and investigates the use of ‘employee empowerment’ techniques - following Carlzon (1987) - to provide a solution. The case illustrates the dysfunctional activity associated with implementing empowerment without either appropriate management control or staff training, together with the dire financial implications. The Teaching Resource Note discusses alternative approaches that might have been adopted.     

Institutional investment in online business lending markets

We provide new insights into the business lending decisions of institutional investors in online credit markets by benchmarking their lending performance against that of retail investors.We find superior performance for loans financed by institutional investors, although large sized retail investor groups achieve equivalent performance. Lending decisions of institutional investors are not default risk minimising, and we quantify lending inefficiencies. From a platform perspective, we show that (i) the platform-administered loan allocation process is not biased in favour of institutional investors, (ii) institutional participation in the retail marketplace is not a distorting factor in loan performance, and (iii) the platform’s move to a fixed rate system had detrimental effects on loan outcomes for institutional investors. The superior loan performance achieved by institutional investors is confined to the auction period, when institutional investors had autonomy over setting interest rates.     

Mutual Fund Performance and the Incentive to Generate Alpha

To rationalize the well‐known underperformance of the average actively managed mutual fund, we exploit the fact that retail funds in different market segments compete for different types of investors. Within the segment of funds marketed directly to retail investors, we show that flows chase risk‐adjusted returns, and that funds respond by investing more in active management. Importantly, within this direct‐sold segment, we find no evidence that actively managed funds underperform index funds. In contrast, we show that actively managed funds sold through brokers face a weaker incentive to generate alpha and significantly underperform index funds.     

金融产品持股与银行系统性风险——兼论《商业银行股权管理暂行办法》的影响

基于金融机构通过金融产品增持上市银行股份现象日益普遍的背景,本文运用2011-2019年上市银行数据,采用系统GMM和合成控制法(SCM),分析金融产品持股¹对银行系统性风险的影响及其异质性,并探讨《商业银行股权管理暂行办法》(以下简称《股权办法》)限制金融产品超比例持有上市银行股份规定的效果。结果表明:(1)当单家金融产品股东的持股比例均低于5%²时,其会利用专业优势更好地监督银行行为,金融产品总持股比例有助于降低银行系统性风险。(2)当第一大金融产品股东的持股比例超过5%时,其会利用话语权为自身牟利,导致银行系统性风险增加,削弱金融产品总持股比例对银行系统性风险的降低作用。(3)由于保险产品持股在金融产品总持股中占主导地位,其对银行系统性风险的影响与金融产品持股的作用一致;保险产品以外的其他金融产品总持股比例会降低银行系统性风险。(4)《股权办法》的实施有助于约束持股比例超过5%的机构投资者的冒险行为,进而降低相应银行的系统性风险。     

Risk classes for structured products: mathematical aspects and their implications on behavioral investors

The new regulation of the EU for financial products (UCITS IV) prescribes Value at Risk (VaR) as the benchmark for assessing the risk of structured products. We discuss the limitations of this approach and show that, in theory, the expected return of structured products is unbounded while the VaR requirement for the lowest risk class can still be satisfied. Real-life examples of large returns within the lowest risk class are then provided. The results demonstrate that the new regulation could lead to new seemingly safe products that hide large risks. Behavioral investors that choose products only based on their official risk classes and their expected returns will, therefore, invest into suboptimal products. To overcome these limitations, we suggest a new risk-return measure for financial products based on the martingale measure that could erase such loopholes.     

Death spiral PIPEs: a reconsideration of the evidence

We challenge the view that PIPEs lead to unfavourable outcomes for issuing firms. We show that structured PIPEs do not have significant negative CARs when a matched firm benchmark is used for computing CARs and when sample selection bias is taken into account. Indeed, structured PIPEs have significantly higher positive skewness, indicating superior optionality, consistent with the real option argument. We also show that the 2002 intervention by the Securities and Exchange Corporation (SEC) has led to unintended consequences, with the substitution of ‘mom and pop’ investors for hedge fund investors in the structured PIPE market.