Complexity as a Proxy for Risk when Evaluating Derivative Securities

Abstract

The overall market for derivative securities is often estimated as more than ten times the World’s GDP and many decry the complexity of derivatives as a main contributor to the subprime financial crisis. In this paper, we investigate whether and why complexity is used as a proxy for risk when evaluating derivatives. We conduct three laboratory experiments to show a robust effect consistent with investors and managers taking complexity as a proxy for risk and deeming more complex, but equally risky, derivatives as worse for risk minimization. We also provide evidence that the effect is driven by negative perceptions (i.e., affect) regarding derivatives. 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, Psychology of Risk, Financial Complexity

JEL Classification: M41, G41