Investment in Financial Structured Products from a Rational Choice Perspective

Abstract

Structured products (SP) are synthetic investment instruments tailored to the specific needs of an investor, which cannot be met through investment in standard financial instruments. Despite the large sums invested in SP, regulation, which adequately addresses issues arising from the investment in these packaged financial instruments is lacking. Many of these issues are unique to SP and do not pertain to investments in stocks, bonds and mutual funds. Analyzing typical structured products by figuring out the underlying financial assets and pricing them, demonstrates a transfer of riskless wealth from the investors to the issuers. We argue that many structured products currently available to retail investors are designed to exploit several common behavioral biases in the area of decision making under uncertainty, including: loss aversion, the disposition effects, herd behavior, the ostrich effect and the hindsight bias. We identify certain characteristics of structured products and analyze the association between these features and the corresponding behavioral bias. To test our argument, we perform an experiment that examines investor decision-making in relation to SP investments. Our findings demonstrate that investors tend to be affected by these behavioral biases, which favor SP investments, despite the fact that a rational assessment of investor welfare would lead to an alternative investment. Accordingly, regulation dealing specifically with SPs may be warranted to improve investor protection.