The Dark Side of Financial Innovation

Abstract

The ability to create securities providing state-contingent payoffs tailored to specific investors seems conducive to improving allocative efficiency. But if some investors assign incorrect probability weights to events, financial institutions can exploit these errors by creating financial instruments that investors overvalue. We analyze the pricing of SPARQS, the most popular listed structured equity product, and document that they are sufficiently overpriced that their expected returns are less than the riskless rate. In a standard model of portfolio selection, such securities would not rationally be purchased by an investor whose marginal utility covaries negatively with the SPARQS returns, and it is difficult to rationalize the SPARQS purchases in the context of a plausible normative model of rational investors. SPARQS are however consistent with the hypothesis that investment banks design structured products to exploit investors' valuation errors.