Complexity as a Proxy for Risk when Evaluating Derivative Securities

34 Pages Posted: 5 May 2020

See all articles by Michael T Durney

Michael T Durney

University of Iowa

Robert Libby

Cornell University - Samuel Curtis Johnson Graduate School of Management

Felipe Bastos G. Silva

University of Missouri, Columbia

Date Written: April 7, 2020

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

Suggested Citation

Durney, Michael Thomas and Libby, Robert and Silva, Felipe Bastos G., Complexity as a Proxy for Risk when Evaluating Derivative Securities (April 7, 2020). Available at SSRN: https://ssrn.com/abstract=3570998 or http://dx.doi.org/10.2139/ssrn.3570998

Michael Thomas Durney (Contact Author)

University of Iowa ( email )

341 Schaeffer Hall
Iowa City, IA 52242-1097
United States

Robert Libby

Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )

Ithaca, NY 14853
United States
607-255-3348 (Phone)
607-254-4590 (Fax)

Felipe Bastos G. Silva

University of Missouri, Columbia ( email )

331 Cornell Hall
Columbia, MO 65211
United States
5738829905 (Phone)

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