The Dark Side of Financial Innovation

There is a paper by Brian Henderson and Neil Pearson soon to be published in the Journal of Financial Economics (pre-publication working paper is available for free here) that documents significant overpricing of a complicated structured equity product marketed by investment banks to retail customers. The authors evaluate a set of SPARQS created by Morgan Stanley between 2001 and 2005. SPARQS stands for Stock Participation Accreting Redemption Quarterly-pay Securities. These are a classic derivative security in that they repackage the payoff from an underlying equity security.

The authors find that on average customers pay 8% above the fair market value for securities. On the assumption that Morgan Stanley is producing a uniquely valuable payoff structure that customers find it difficult to produce for themselves, it could make sense that the bank might charge a premium. In fact, it would have to in order to cover its own costs of manufacturing the payoff. However, the size of the premium in this case is very large. So large, in fact, that the authors document that customers should expect to earn less than the risk-free rate of interest. Moreover, the payoff structure seems to be similar to what can be obtained from more pedestrian securities already easily obtained in the marketplace. So the product offers no unique hedging value that could offset the high price paid. The authors point out that “…most SPARQS investors would likely have been better off investing in non-interest bearing accounts.”

Henderson and Pearson present the results as a challenge to the claim that financial innovation always makes the world better.

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 darkside 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 payoff in the states that investors overweight and payoff 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.

It will be interesting to see if someone challenges the valuations or the argument made with them.

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