The Valuation of Composite Investment Instruments

Abstract

The return on composite investment instruments takes the form of weighted-average, derived from the performance of at least two economic indicators. Three allocation experiments illustrate that prospective investors tend to valuate composites "by-tranche", consistently violating the rational premise of reduction. Valuation-by-tranche shows for uncertain and risky composites, and reflects in allocation problems and binary choice. The willingness to invest in a given composite still strongly increases when one tranche hedges against the other, suggesting that reduced-form considerations might interfere with the inclination to value components separately. A hybrid model where investors weight the values of underlying tranches, but also respond to the reduced-form prospect, approximates the data most accurately. Personal tendency to valuate composites by-tranche negatively correlates with choice consistency, suggesting that component-level processing might bias investment decision and open space for profitable composite engineering.

Keywords: Composite investment; reduction; prospect theory; restricted loss aversion; increasing marginal disutility of loss

JEL Classification: D81; D14; C91