The field of household finance is concerned with the study of how households make investment decisions to attain their objectives. Campbell (2006) in his presidential address highlighted the importance of studying this neglected field. There is often considerable disparity between the predictions of the standard finance models and what households actually do in practice. Campbell notes that the distinction between positive and normative models poses a particular challenge in the context of household finance and suggests that these discrepancies are central to the field of household finance.
The current paper discusses these issues in the context of consumer choice in the market for structured retail financial products. This is an important market and these products represent one of the ways in which many investors gain exposure to equity markets. The typical contract has a payoff based on the performance of an equity portfolio, so that the investor benefits from good stock market performance. At the same time, the contract often provides a minimum guaranteed floor that gives protection in the case of poor equity returns. The cost of the guarantee is generally covered by modifying the payoff for example capping it at some level. Such products have a strong consumer appeal since they combine upside appreciation in bull markets with downside protection in bear markets in a single unified contract. In this paper, we will consider products which have an underling floor guarantee as well as a cap.
The simplest versions of such a contract can be viewed as a portfolio of a long position in a zero-coupon bond and a call option on the underlying equity portfolio. While there are some contract designs similar to this in the market, the vast majority of contracts have more complicated designs. The ultimate payoff to the investor is generally capped to cover the cost of the guarantee. For example, the terminal payoff may be based on the sequence of realized returns on the equity portfolio where each return is capped at a specific level. The floor guarantee can be based on the entire life of the contract or there could be a minimum return each year of, say, zero per cent. Other aspects of the design make these contracts difficult for the typical investor to understand. Their complexity makes it very hard for consumers to make price comparisons across the different products.
In this paper, we describe and analyze a popular class of structured products. These contracts are subject to periodic caps with a maturity guarantee and are known as locally-capped, globally-floored contracts. We show that they are dominated by consistently priced contracts with a single cap at maturity and the same type of floor. Similar inefficiencies have been observed in other financial decisions made by consumers (See Campbell (2006) and Carlin (2006)). Henderson and Pearson (2007) also find puzzling investor behavior in the structured products market and note “it is difficult to rationalize investor demand for structured equity products within any plausible normative model of the behavior of rational investors.”
Retail structured products tend to be overpriced (Stoimenov and Wilkens (2005), Henderson and Pearson (2007)) and also highly complex. The existence of overpriced complex financial products is consistent with Carlin’s (2006) model where producers of retail financial products take advantage of financially naive consumers by consciously making these products complicated. In Carlin’s model, firms strategically increase the complexity of financial products to preserve market power and bound the financial literacy of consumers. Moreover the sellers are able to charge a higher markup on the more complex products. In most cases, the retail investor does not have the expertise to understand the complexities of these contracts and obtains advice from an agent who is remunerated by sales commissions. If the producer’s surplus is shared with the sales agent, then there are incentives for the agent to push the more complex products and for the industry to favor a regulatory regime that makes it easier to avoid disclosure and complicate the product.
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Structured Investment Products and the Retail Investor
