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The Dark Side of Financial Innovation

39 Pages Posted: 16 Feb 2009 Last revised: 14 Feb 2010

Brian J. Henderson

George Washington University - Department of Finance

Neil D. Pearson

University of Illinois at Urbana-Champaign - Department of Finance

Date Written: February 13, 2009

Abstract

The ability to create securities providing state-contingent payoffs tailored to specific investors seems conducive to improving allocative efficiency. But if some investors assign incorrect probability weights to events, financial institutions can exploit these errors by creating financial instruments that investors overvalue. We analyze the pricing of SPARQS, the most popular listed structured equity product, and document that they are sufficiently overpriced that their expected returns are less than the riskless rate. In a standard model of portfolio selection, such securities would not rationally be purchased by an investor whose marginal utility covaries negatively with the SPARQS returns, and it is difficult to rationalize the SPARQS purchases in the context of a plausible normative model of rational investors. SPARQS are however consistent with the hypothesis that investment banks design structured products to exploit investors' valuation errors.

Keywords: structured products, valuation errors, cognitive biases, individual investor

JEL Classification: G24, G28, G32

Suggested Citation

Henderson, Brian J. and Pearson, Neil D., The Dark Side of Financial Innovation (February 13, 2009). EFA 2009 Bergen Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1342654 or http://dx.doi.org/10.2139/ssrn.1342654

Brian Joseph Henderson

George Washington University - Department of Finance ( email )

Department of Finance, Funger Hall
2201 G Street, NW
Washington, DC 20052
United States
202-994-3669 (Phone)

Neil D. Pearson (Contact Author)

University of Illinois at Urbana-Champaign - Department of Finance ( email )

1206 South Sixth Street
Champaign, IL 61820
United States
217-244-0490 (Phone)
217-244-9867 (Fax)

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