The dark side of financial innovation: A case study of the pricing of a retail financial product☆
Introduction
We carry out a detailed analysis of the pricing and expected returns of 64 issues of a popular structured equity product. Our pricing results imply that, on average, across the 64 issues, purchasers of the products lock in negative abnormal returns of at least 8% per year relative to dynamically adjusted portfolios of the underlying stock and bonds with the same risk. This negative abnormal return is large enough that under the most reasonable assumptions about the expected returns of the underlying stocks, the mean of the estimates of the expected returns on the structured products is less than zero. Given that the products returns covary positively with the broad market indexes and that the products do not appear to offer tax, liquidity, or other benefits, it is difficult to rationalize their purchase by informed rational investors. These findings are difficult to reconcile with the long standing view that financial innovations help issuers and (rational) investors achieve desired goals in the presence of market imperfections.
Much of the extant literature portrays financial innovations as helping economic agents achieve a desired function in the presence of one or more market inefficiencies or imperfections.1 For example, new securities may be created to enable investors to achieve desired payoffs not spanned by the previously available financial instruments, or loosely to complete markets. Ross (1976) takes this “spanning” view of financial innovation in arguing that the introduction of option contracts improves allocative efficiency when the previously existing set of securities fails to span the state space.2 Other research presents financial innovations as arising to ameliorate imperfections such as agency conflicts (Ross, 1989), to reduce transactions costs (Ross, 1989, McConnell and Schwartz, 1992, Grinblatt and Longstaff, 2000), and to minimize the impact of taxes or regulations (Miller, 1986, Santangelo and Tufano, 1996). A common element in these papers is that financial innovations arise in response to market imperfections or inefficiencies and provide the benefit of ameliorating at least one imperfection or inefficiency.3 This generally benign view of financial innovation is unsurprising, since, as noted by Tufano (2003), “bringing new securities to market requires the voluntary cooperation of both issuers and investors.”
Financial institutions ability to create securities providing state-contingent payoffs tailored to the needs or desires of specific investors or groups of investors seems especially conducive to achieving these potential benefits. But there is a dark side to the ability to create instruments with tailored payoffs. If some investors misunderstand financial markets or suffer from cognitive biases that cause them to assign incorrect probability weights to events, financial institutions can exploit the investors mistakes by creating financial instruments that pay off in the states that investors overweight and pay off less highly in the states that investors underweight, leading the investors to value the new instruments more highly than they would if they understood financial markets and correctly evaluated information about probabilities of future events. In addition, the ability to create instruments with almost any payoffs implies that there are few limits on the complexity of financial instruments. A recent theoretical literature explores equilibria in which firms shroud some aspects of the terms on which their products are offered in order to exploit uninformed consumers (Gabaix and Laibson, 2006), and strategically create complexity to reduce the proportion of investors who are informed (Carlin, 2009). In these equilibria, prices are higher than they would be if consumers or investors were fully informed. In the context of structured equity products (SEPs), these arguments imply that markups or premiums are higher and returns lower than they otherwise would be.
We provide evidence that this darker view of financial innovation is likely to apply to offerings of at least some retail financial products by focusing on the initial pricing of Stock Participation Accreting Redemption Quarterly-pay Securities (SPARQS), a subset of the U.S. publicly issued SEPs. SEPs are medium-term notes issued by financial institutions and have payments based on another company's common stock price, multiple common stock prices (e.g., baskets of common stocks), a stock index, or multiple stock indexes. They are designed and issued by banks and investment banks and typically marketed to retail investors. SPARQS, created and marketed by Morgan Stanley, are the most popular of the publicly offered SEPs with payoffs based on the prices of individual common stocks.
We find that the primary market investors pay, on average, an 8% premium for these securities, where the premium is defined as the difference between the offering price and an estimate of the fair market value. This is a large premium for a product that is callable after about six months and has a maximum maturity of slightly more than one year, as it implies that the purchaser locks in a negative abnormal return of at least 8% per year relative to a dynamically adjusted portfolio of the underlying stock and bonds with the same risk. Examination of the behavior of the secondary market price premiums to the model values over time indicates a gradual adjustment toward the model values.
These premiums are large enough, and the expected lives of the SPARQS short enough, that under the objective measure the expected returns on the SPARQS are less than the risk-free rate of interest. In a standard model of portfolio choice, such a security is rationally purchased by an investor only if its returns covary positively with the investor's marginal utility (Merton, 1982). The returns of the SPARQS covary positively with the broad market indexes, and for the vast majority of investors, almost certainly covary positively with consumption and negatively with marginal utility. Thus, it is difficult to rationalize primary market purchases of SPARQS by investors who hold portfolios that are positively correlated with or uncorrelated with the broad market indexes. With such SPARQS investors would have been better off investing in bank certificates of deposit.4
It is unlikely that SPARQS satisfy any hedging needs of retail investors. The payoffs of SPARQS are qualitatively similar to those of covered calls, but SPARQS are callable by the issuer at a time-varying schedule of call prices, complicating their use as hedging instruments. Even for positions such as naked purchased put options for which SPARQS at first glance seem like a reasonable hedge, hedges involving ordinary exchange-traded options and the underlying stock seem more natural. The SPARQS also do not provide tax advantages, are not particularly liquid, and do not appear to help investors avoid transactions costs.
In a complementary paper, Bergstresser (2008) presents evidence on the abnormal returns of a broad sample of SEPs that is consistent with our findings of overpricing on the offering date. Other researchers who have found that investors pay more than the fair market values for innovative securities include Rogalski and Seward (1991) and Jarrow and O’Hara (1989), who examined foreign currency warrants and primes and cores, respectively. These researchers argue that the securities they consider provide hedging benefits to investors, so their results do not have the negative implications for the products that ours do. (Benet, Giannetti, and Pissaris, 2006) consider the valuation of U.S. reverse exchangeable securities, and suggest that credit enhancement due to the positive correlation between the payoffs and the issuer financial performance and possible tax benefits might explain investor demand. Outside the U.S. markets, Szymanowska, Horst, and Veld (2009) estimate the values of reverse exchangeable securities issued in The Netherlands by ABN AMRO with payoffs based on the prices of other common stocks, while Baule, Entrop, and Wilkens (2008) calculate margins in the German retail structured products market using a sample of German “discount certificates” based on the prices of individual common stocks. Burth, Kraus and Wohlwend (2001) provide evidence about the pricing of Swiss structured products based on individual equities, which also have sizable markups. None of these researchers estimates the expected returns under the objective measures, so again their results do not have the negative implications about the products that ours do.5
The next section of the paper briefly describes the market for SEPs and the SPARQS that are the focus of our analysis. Section 3 analyses the initial pricing of the SPARQS and their post-issue performance. Section 4 departs from the risk-neutral measure used for valuation and shows that reasonable estimates of expected returns under the objective measure are less than the riskless rate. Section 5 explores the determinants of SPARQS issuances, and Section 6 discusses the implications of our findings and briefly concludes.
Section snippets
Retail structured equity products
Structured equity products evolved from related equity-linked instruments that were issued in the 1980s.6 These predecessor instruments typically were issued by non-financial corporations, and were underwritten by investment banks in the same way that other corporate securities often are. These predecessor instruments typically converted into, or had payoffs based on, the issuing firm's common stock.
Pricing and post-issue returns of the SPARQS
From June 2001 through December 2005, Morgan Stanley issued 69 SPARQS. Of these 69 issues, 64 were listed and traded on the Amex and the remaining five issues were not listed on any exchange. This section of the paper presents estimates of the premiums or markups for the 64 SPARQS issued by Morgan Stanley and listed on the Amex, where the premium is defined as the percentage difference between the offering price and a model-based estimate of the fair market value. It also examines the SPARQS
Expected returns of the SPARQS
The analysis in Section 3 provides evidence of large markups on the SPARQS and post-issuance underperformance consistent with the large markups. Given that the SPARQS have original maturities of only slightly more than one year and many issues are called after six months, the markups are large enough to suggest that the expected returns of the SPARQS might be less than the risk-free rate of interest. This section presents evidence that this is in fact the case for reasonable estimates of the
Determinants of SPARQS issuances and premiums
Morgan Stanley may select virtually any stock as the underlying asset of a SPARQS issue, and may issue a SPARQS on any date. This section presents the results of logistic regressions that explore the determinants of these SPARQS issuances. The explanatory variables we consider include returns and trading volume over several past periods, which are plausibly proxies for investor attention, a measure of implied volatility, measures of option trading volume, and the (log of the) market
Discussion and conclusion
We present evidence that the initial offering prices of SPARQS, the most popular of the publicly offered U.S. retail structured equity products, include “markups” or premiums large enough that the SPARQS have expected returns less than the riskless rate. What conclusions should one draw from this?
Due to marketing costs, the offering prices of virtually all retail financial products must include premiums over estimates of their fair values. The equal- and value-weighted average commissions on
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We thank Gurdip Bakshi, Raoul Minetti, Jacob Sagi, Mark Shackleton, Marco Wilkens, seminar participants at Hong Kong University of Science and Technology and the U.S. Securities and Exchange Commission, conference participants at the China International Conference in Finance 2009, European Finance Association 2009, European Financial Management Association 2009, Financial Intermediation Research Society 2009, the Adam Smith Asset Pricing Conference 2010, and especially an anonymous referee for helpful comments. Much of the work on this paper was done while Neil Pearson was a Visiting Professor at the MIT Sloan School of Management.
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