Can Financial Innovation Succeed by Catering to Behavioral Preferences? Evidence from a Callable Options Market

Abstract

We examine the notion that financial products which cater to investors' behavioral biases can attain popularity and yield substantial profits for issuers. Our setting considers options with a callback feature, namely, callable bull/bear contracts (CBBCs). These 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 issuer profits vary positively with CBBC skewness. Over the 2009-2014 period, issuers earn (investors lose) the equivalent of $1.66 billion by trading CBBCs on the Hang Seng index. These findings highlight the role of behavioral finance in financial innovation.

Keywords: Lotteries; Gambling; Financial Innovation; Cumulative Prospect Theory; Callable Bull/Bear Contract (CBBC); Turbo Warrant

JEL Classification: D03, D81, G02, G12, G23