Discussion of Recent Developments in Retail Finance

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Discussion ofRecent Developments in Retail
Finance

• by
• Daniel Dorn, Drexel UOctober 20, 2008

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Overview

• Bank-issued derivatives completing markets or
  exploiting retail investors biases?- Locally
  capped, globally floored contracts
  (Bernard/Boyle)- Endless leverage certificates
  (Rosetto/van Bommel)
• Effect of insurance products on economic
  growth(Haiss/Sümegi)

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2007 Comparison

• Euwax
• Trading volume of 128 billion
• 64 annual growth(3 years)
• 250,000 instruments
• 74 annual growth(3 years)

• Eurex
• Trading volume of 455 billion
• 58 annual growth(3 years)
• 15,000 instruments

• Frankfurt
• Tradingvolume ofgt 2,000 billion
• 39 annual growth(3 years)
• 10,000 stocks
• 17 annual growth (3 years)

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(Bank-Issued) Derivativesand Their Retail Traders

• Higher prices than theoretical values delivered
  by option pricing models premium appears to
  decline over time
• Substantial fees associated with complex
  structures
• Retail traders habitually engage in behavior at
  odds with standard models- exercise American
  calls (too early)- trade derivatives extra
  aggressively- exhibit a disposition effect

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(Bank-Issued) Derivativesand Their Retail Traders

• Unclear whether portfolio optimization even with
  frictions generates positive demand for these
  products
• Driessen/Maenhout (2007) given historical
  options prices, optimal to short index puts, for
  most levels of risk aversion and different
  preferences
• How important is market completion to retail
  investors for many of whom hedging appears to be
  an unimportant investing/trading motive?

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Bernard/Boyle (1)

• Locally-capped, globally-floored, contract
• Example of payoff at maturity per contract

• Equivalent contract with global cap, global floor

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Bernard/Boyle (2)

• Global caps should be preferred by risk-averse
  enough investors
• Global caps are easier to hedge
• Yet, most (all?) contracts have local caps
• Risk preferences (prospect theory) might help
  explain the popularity of local caps
• The probability of repeatedly attaining local
  caps is implicitly exaggerated by the issuer

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Bernard/Boyle (3)

• Are locally-capped products overpriced (relative
  to globally-capped products)?
• Unless investors frame narrowly or are risk
  neutral, utility analysis of individual financial
  assets offers limited insights
• Why would risk-neutral agents pay for portfolio
  insurance? (weaker results seem unproblematic,
  why include them in the paper?)

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Rosetto/van Bommel (1)

• Long endless leverage certificate (ELC)
• Underlying St, strike Xt, and knock-out barrier
  Bt, due when StltBt for the first time
• At due, holder receives max0, St-Xt)
• Every day, the strike price increases bya factor
  of 1 rt z, where rt is the money market rate
  and z is a funding rate/credit spread set by the
  issuer
• Issuer also sets a factor agt0 s.t. Bt (1a) Xt

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Rosetto/van Bommel (2)

• ELCs are easy and cheap to hedge- at the
  outset, buy a share for S0- borrow X0- sell ELC
  for S0-X0
• Issuer, however, exposed to gap risk chance
  that St plummets below Bt and Xt before issuer
  can unwind the hedge
• Instruments appear fairly priced and
  competitively traded

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Rosetto/van Bommel (3)

• ELC payoffs are easy to replicate for retail
  investors useful financial innovation or
  successful marketing?
• Entrop et al. (JBF, forthcoming) Pricing of
  ELCs favors the issuer even accounting for gap
  risk when investors hold ELCs too long (mainly
  driven by credit spread z)
• Present paper ELCs fairly priced assuming
  rational investors who exercise/sell back the
  security at the right time
• Do they? It seems that at least some ELC
  holders exit their positions too late (p17)

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Growth in Bank-Issued Derivatives Completing
Markets or Exploiting Retail Investors Biases?

• Speculation
• Probably both benefits and cost increase with
  growth
• Costs increase faster than benefits- given
  technology, most beneficial innovations first-
  increasing complexity (products, number of
  products, trading venues) makes it increasingly
  harder to choose well ? optimal to stay
  uninformed for larger fraction of retail investors

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Haiss and Sümegi (1)

• Effect of insurance on GDP growth
• Focus on old and new EU member countries
• Investigation of risk transfer and investment
  functions
• Important and ambitious research question

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Haiss and Sümegi (2)

• What mechanism causes higher growth?
• In general, empirical results appear to be weak
• Does insurance have an effect above and beyond
  that of the development of financial markets and
  other financial intermediaries?

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Additional slides
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(No Transcript)
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Trading venuesfor bank-issued derivatives
Source derivatives trades of 1/2 the
population of clients at a large German discount
broker
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Prices differ across venues

• People pay 1.6 more when buying from the issuer
  than when buying on the exchange, on average
• People get 0.8 less when selling to the issuer
  than when selling on the exchange, on average
• After-hours trading with greater spreads?

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Regulations and costs BAFIN

• Draw up a prospectus according to German
  securities prospectus law- base prospectus,
  valid one year for several derivatives issues-
  registration form specific to each issue
• Approval within 10 business days, 1,000
• Costs of publishing the prospectus

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Regulations and costs Euwax

• Issuer becomes or hires market maker
• Admissions fee 125 (10,000 cap)
• Listing fee 250 (20,000 cap)
• Quotation fee 125 (10,000 cap)