Can financial innovation succeed by catering to behavioral preferences? Evidence from a callable options market

Research output: Journal Publications and Reviews (RGC: 21, 22, 62)21_Publication in refereed journalpeer-review

17 Scopus Citations
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Author(s)

Detail(s)

Original languageEnglish
Pages (from-to)38-65
Journal / PublicationJournal of Financial Economics
Volume128
Issue number1
Online published9 Feb 2018
Publication statusPublished - Apr 2018
Externally publishedYes

Abstract

We examine the notion that financial products which cater to investors’ behavioral biases can yield high trading activity and thus be profitable for issuers. Our setting considers options with a callback feature, namely, callable bull/bear contracts (CBBCs). Such contracts have high skewness when close to callback and thus appeal to cumulative prospect theory preferences. CBBCs with high skewness earn negative average returns, and issuers’ gross profits vary positively with CBBC skewness. Over the 2009–2014 period, issuers earn gross profits of about $1.67 billion by trading CBBCs on the Hang Seng Index. These findings highlight the role of behavioral finance in financial innovation.

Research Area(s)

  • Lotteries, Gambling, Financial innovation, Cumulative prospect theory, Callable bull/bear contract (CBBC)