How does pricing affect investors’ product choice? Evidence from the market for discount certificates

Abstract

This paper examines the choices of retail investors in the market for structured financial products with a focus on implicit and explicit pricing components. We evaluate more than 72,000 single stock discount certificates on a daily basis from 2004 through 2008. The certificates are quoted an average of 0.58% above their fair value before the financial crisis, increasing to 1.24% during 2008. Although credit risk explains a major part (39%) of the certificates' overpricing, we find that issuer default risk does not have any influence on investors' product choices. Instead, retail investors are strongly influenced by irrational factors such as issuer and product familiarity. Finally, investors are found to make poor product choices (in terms of bid/ask spreads and markups over fair value), resulting in significant losses.

Pricing effects when competitors arrive: The case of discount certificates in Germany

“…Examining the trading behavior of retail investors in leveraged certificates, Meyer, Schroff, and Weinhardt (2014) find that the release of news on the underlying comes with much higher trading activity, but not with higher performance. Entrop et al (2015) find that familiarity with the product or issuer determines retail investors' purchasing behavior.…”

“…If retail investors fail to valuate credit risk differences appropriately, the two prices might differ only by a small amount that is not related to the actual credit risk difference between the two issuers. Indeed, Entrop et al (2015) find that issuers' credit risk does not determine which certificate a retail investor purchases. Then, the issuer with low credit risk offers its product at a higher price than the issuer with high credit risk, though both offer products only as long as their profit components are non-negative (thus, instead of losing money by requesting low prices, issuers may opt to leave the market).…”

“…However, some researchers argue that retail investors may lack the knowledge or suffer from behavioral biases, preventing them from dealing with the effects of issuers' credit risk on products' values adequately (Baule, Entrop, and Wilkens, 2008;Entrop, Fischer, McKenzie, Wilkens, and Winkler, 2015). I argue that in this situation, under particular circumstances the competition mechanism might be reverted such that issuers increase the prices of master certificates when they have higher credit risk than duplicate issuers.…”

“…Relevant for my identification strategy is the finding by Baule and Blonski (2015) for bankissued warrants and Entrop et al (2015) for discount certificates. They find that retail investors demand products with round strikes more intensely than products without.…”

“…So far, the literature has only investigated how issuers' credit risk affects their price setting (e.g., Baule, 2011) and retail investors' trading behavior (Entrop et al, 2015). Third, this study employs difference-in-differences estimations in the case of structured financial products.…”