Risk Classes for Structured Products: Mathematical Aspects and their Implications on Behavioral Investors

Abstract

The new regulation of the EU for financial products (UCITS IV) prescribes Value at Risk (VaR) as the benchmark for assessing the risk of structured products. We discuss the limitations of this approach and show that, in theory, the expected return of the structured product is unbounded while the VaR requirement for the lowest risk class can still be satisfi ed. Real-life examples of large expected returns within the lowest risk class are then provided. The results demonstrate that the new regulation could lead to new seemingly safe products that hide large risks. Behavioral investors that choose products only based on their official risk classes and their expected returns will therefore invest into suboptimal products. To overcome these limitations, we suggest a new risk-return measure for financial products based on risk-neutral probabilities that could erase such loopholes.