The Dynamics of Overpricing in Structured Products

Abstract

Issuers of structured products have great power when setting the price of their securities. Each issuer is the sole liquidity provider in the secondary market for her products, and short-selling is not possible. Using a large, high-frequency data set, we investigate the pricing dynamics of a class of structured products, bank-issued warrants, and show that issuers use their monopoly powers to extract wealth from investors. First, we find that warrants are more overpriced the harder they are to evaluate, and the fewer substitutes are available. Second, issuers are able to anticipate demand in the short term and preemptively adjust prices for warrants upwards (downwards) on days when investors are net buyers (sellers). Third, issuers decrease the amount of overpricing over the lifetime of most warrants, lowering returns for investors further. Lastly, while we find a negative relationship between issuer credit risk and overpricing, the effect is generally too small, is absent prior to the Lehman Brothers bankruptcy and does not conform to models of vulnerable options. Thus, issuers gain access to cheap financing.

Keywords: Structured Products, Default Risk, Retail Investors, Overpricing

JEL Classification: G11, G13, G21, G33