Low Interest Rates, Bounded Rationality, and Product Complexity: Demand and Supply Effects for Retail Financial Markets
72 Pages Posted: 30 Dec 2019 Last revised: 15 Jun 2020
Date Written: December 6, 2019
This paper studies the market for yield enhancement products (YEPs). We document a substantial increase in volumes, followed by a striking rise in product complexity. This pattern is paralleled by sharply falling and plateauing interest rates. We experimentally show that, while decreasing interest rates increase individuals' willingness to bear risk, it is their risk misestimation that creates demand for more complex products. By analyzing 4,460 issued YEPs, we find that (i) issuer margins are increasing in product complexity, (ii) average investment returns are negative, (iii) product complexity appears driven by supply competition and caters to investors' bias in perceiving dependencies.
Keywords: Financial innovation; complexity; retail finance; reaching for yield; dependency perception
JEL Classification: G4, D14, E44, G13, G18
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