Derivative Complexity as a Determinant of Perceived Risk

Abstract

While derivative securities are a critical component of the global economy, the complexity of derivatives is decried as a contributor to financial crises and investor losses. However, derivative complexity is not necessarily related to risk and more complex derivatives may even result in less risk. In this paper, we use five experiments to investigate whether and why derivative complexity is interpreted as a determinant of risk by participants with varying levels of sophistication, including highly experienced professional investors, using both between- and within-participants manipulations of derivative complexity. Results collectively document a robust effect wherein more complex derivatives are evaluated as riskier, contrary to any actual risk differences. Process evidence suggests the effect is driven, at least in part, by attribute substitution. We also document a potential solution via firm disclosure to alleviate this effect, which otherwise might result in misunderstanding of risk based on derivative disclosures required by US GAAP (ASC 815-10-50).

Keywords: derivative securities, attribute substitution, financial complexity, risk perceptions, retail investors, professional investors

JEL Classification: G23, M41, M48, M49