Can Financial Innovation Succeed by Catering to Behavioral Preferences? Evidence from a Callable Options Market

76 Pages Posted: 23 Jan 2014 Last revised: 10 Mar 2017

See all articles by Xindan Li

Xindan Li

Nanjing University

Avanidhar Subrahmanyam

University of California, Los Angeles (UCLA) - Finance Area; Institute of Global Finance, UNSW Business School; Financial Research Network (FIRN)

Xuewei Yang

Nanjing University - School of Management and Engineering

Date Written: March 9, 2017

Abstract

We examine the notion that financial products which cater to investors' behavioral biases can attain popularity and yield substantial profits for issuers. Our setting considers options with a callback feature, namely, callable bull/bear contracts (CBBCs). These contracts have high skewness when close to callback and thus appeal to cumulative prospect theory preferences. CBBCs with high skewness earn negative average returns, and issuer profits vary positively with CBBC skewness. Over the 2009-2014 period, issuers earn (investors lose) the equivalent of $1.66 billion by trading CBBCs on the Hang Seng index. These findings highlight the role of behavioral finance in financial innovation.

Keywords: Lotteries; Gambling; Financial Innovation; Cumulative Prospect Theory; Callable Bull/Bear Contract (CBBC); Turbo Warrant

JEL Classification: D03, D81, G02, G12, G23

Suggested Citation

Li, Xindan and Subrahmanyam, Avanidhar and Yang, Xuewei, Can Financial Innovation Succeed by Catering to Behavioral Preferences? Evidence from a Callable Options Market (March 9, 2017). Journal of Financial Economics (JFE), Forthcoming. Available at SSRN: https://ssrn.com/abstract=2382611 or http://dx.doi.org/10.2139/ssrn.2382611

Xindan Li

Nanjing University ( email )

Nanjing, Jiangsu 210093
China

Avanidhar Subrahmanyam

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-5355 (Phone)
310-206-5455 (Fax)

Institute of Global Finance, UNSW Business School

Sydney, NSW 2052
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

Xuewei Yang (Contact Author)

Nanjing University - School of Management and Engineering ( email )

22 Hankou Road, Gulou District
Nanjing, Jiangsu 210093
China

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