Derivative Complexity as a Key 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. In this paper, we use four experiments to investigate whether and why complexity is interpreted as a key risk determinant when evaluating derivatives. Our first two experiments show a robust effect consistent with investors and managers interpreting complexity as a key risk determinant and deeming more complex, but equally risky, derivatives as more risky. Our next two experiments provide evidence that the effect is driven by attribute substitution. Altogether, our results shed light on how derivatives are evaluated and suggest an important potential source of misinterpretations of disclosures provided under US GAAP (ASC 815-10-50).

Keywords: Derivative Securities; Attribute Substitution; Financial Complexity

JEL Classification: G23, M41, M48, M49