Just as mushrooms sprout
when it rains, structured
products have a tendency
to blossom during times of
crisis. This is not a
coincidence, we are talking
about instruments that
were in certain ways
designed to exploit fear.
And what better condition for that than a full-scale market crisis?
Structured products do borrow some of its cues from behavioral finance. Loss aversion and the endowment effect are two well-established psychological biases that tend to kick in when things turn sour. Take the basic notion of loss as an example. Nobody likes to lose, whatever the circumstances. Studies show that the sensation of pain to a loss is roughly double in size to the pleasure effect we obtain from a gain of similar magnitude1. No wonder we hate to lose!
As for the endowment effect, it has to do with our dislike for moving out of the “status quo”. We prefer to stick to our “comfort zone” than change to something else. The uncertainty that “change” engenders is perceived as a risk, which explains our dislike for it.
Structured products somewhat exploit these two biases in addition to a third one known as “framing”. Framing has to do with the manner in which a choice is presented to someone2. Due to our cognitive biases, our decision on what option to choose from is very much dependent on the way it has been presented to us.
On October 6 of this year, a well-established financial firm that I will not name issued a structured note linked to a broad and popular stock index. The condition stipulated that if the return on the index was anywhere within a maximum loss of 15% and a maximum gain of 25% by maturity (which is in January 2017), the investor will cash in a 21% return. If, on the other hand, the performance of the index ended somewhere beyond those limits, the investor would only get the principal back3.
Now let us analyze this note in context to the biases mentioned earlier. With regard to the “framing” cognitive bias, it is interesting to note that this product was issued at a time when market volatility was rising sharply, creating an environment of uncertainty and fear. Offering a note where the worst outcome would be that you get your initial investment back is an attractive proposition when sentiment turns to fear.
The next interesting aspect of the way this note has been structured has to do with the price triggering limits. Notice that the gain-triggering limit at 25% is more than the loss- triggering limit of 15%. It is a classic play on the “loss aversion” bias but also misleading because gains are in fact canceled if either limit is breached. Inverting the price limits (i.e. 25% on the downside and 15% on the upside) would make it a more attractive proposition but the issuer seems to think that framing it with the loss aversion bias in mind would make it more attractive4 to the buyer.
Last but not least comes the endowment effect. Take the case of an investor that has made considerable gains from the stock market right before a market crisis erupts. That investor may wish to lock in those gains over a long enough time horizon for the “storm” to subside, but without staying completely out of the markets. They are concerned by the surge in volatility and don’t want to risk venturing too much out of their “comfort zone”5.
Similarly for the investor who experiences major losses following a market correction and wishes to limit any further losses going forward. The instrument gives them a chance to gain substantial returns within a time frame and also provides a cushion in the event that things turn really nasty.
All this is good and structured products certainly do have their place, but caveats abound. For one, these complex and opaque instruments carry substantial fees that the investors are typically unaware of, making them extremely profitable to issuers. More importantly, in certain adverse market conditions, the investor risks losses that go beyond the contractual promises of the instrument6. Food for thought...
1 Kahneman, D. and Tversky, A. (1984). "Choices, Values, and Frames". American Psychologist
2 Tversky, Amos; Kahneman, Daniel (1981). "The Framing of decisions and the psychology of choice".
3 It should be noted that only the principal or original investment is returned to the purchaser of this instrument, excluding dividend payments and/or interest. In the event that the limits are breached, and only the principal is returned, the investor will end up worse off than if he or she had bought a treasury type bond with the same maturity instead.
4 Clearly the triggering price limit settings are also influenced and constrained by option pricing and the aim of maximizing profitability for the issuer.
5 In this example, the “comfort zone” has been established by a protracted period of low market volatility. The change in volatility is what is triggering a move out of this “comfort zone”.
And what better condition for that than a full-scale market crisis?
Structured products do borrow some of its cues from behavioral finance. Loss aversion and the endowment effect are two well-established psychological biases that tend to kick in when things turn sour. Take the basic notion of loss as an example. Nobody likes to lose, whatever the circumstances. Studies show that the sensation of pain to a loss is roughly double in size to the pleasure effect we obtain from a gain of similar magnitude1. No wonder we hate to lose!
As for the endowment effect, it has to do with our dislike for moving out of the “status quo”. We prefer to stick to our “comfort zone” than change to something else. The uncertainty that “change” engenders is perceived as a risk, which explains our dislike for it.
Structured products somewhat exploit these two biases in addition to a third one known as “framing”. Framing has to do with the manner in which a choice is presented to someone2. Due to our cognitive biases, our decision on what option to choose from is very much dependent on the way it has been presented to us.
On October 6 of this year, a well-established financial firm that I will not name issued a structured note linked to a broad and popular stock index. The condition stipulated that if the return on the index was anywhere within a maximum loss of 15% and a maximum gain of 25% by maturity (which is in January 2017), the investor will cash in a 21% return. If, on the other hand, the performance of the index ended somewhere beyond those limits, the investor would only get the principal back3.
Now let us analyze this note in context to the biases mentioned earlier. With regard to the “framing” cognitive bias, it is interesting to note that this product was issued at a time when market volatility was rising sharply, creating an environment of uncertainty and fear. Offering a note where the worst outcome would be that you get your initial investment back is an attractive proposition when sentiment turns to fear.
The next interesting aspect of the way this note has been structured has to do with the price triggering limits. Notice that the gain-triggering limit at 25% is more than the loss- triggering limit of 15%. It is a classic play on the “loss aversion” bias but also misleading because gains are in fact canceled if either limit is breached. Inverting the price limits (i.e. 25% on the downside and 15% on the upside) would make it a more attractive proposition but the issuer seems to think that framing it with the loss aversion bias in mind would make it more attractive4 to the buyer.
Last but not least comes the endowment effect. Take the case of an investor that has made considerable gains from the stock market right before a market crisis erupts. That investor may wish to lock in those gains over a long enough time horizon for the “storm” to subside, but without staying completely out of the markets. They are concerned by the surge in volatility and don’t want to risk venturing too much out of their “comfort zone”5.
Similarly for the investor who experiences major losses following a market correction and wishes to limit any further losses going forward. The instrument gives them a chance to gain substantial returns within a time frame and also provides a cushion in the event that things turn really nasty.
All this is good and structured products certainly do have their place, but caveats abound. For one, these complex and opaque instruments carry substantial fees that the investors are typically unaware of, making them extremely profitable to issuers. More importantly, in certain adverse market conditions, the investor risks losses that go beyond the contractual promises of the instrument6. Food for thought...
1 Kahneman, D. and Tversky, A. (1984). "Choices, Values, and Frames". American Psychologist
2 Tversky, Amos; Kahneman, Daniel (1981). "The Framing of decisions and the psychology of choice".
3 It should be noted that only the principal or original investment is returned to the purchaser of this instrument, excluding dividend payments and/or interest. In the event that the limits are breached, and only the principal is returned, the investor will end up worse off than if he or she had bought a treasury type bond with the same maturity instead.
4 Clearly the triggering price limit settings are also influenced and constrained by option pricing and the aim of maximizing profitability for the issuer.
5 In this example, the “comfort zone” has been established by a protracted period of low market volatility. The change in volatility is what is triggering a move out of this “comfort zone”.
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