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

Xindan Li, Avanidhar Subrahmanyam and Xuewei Yang

Journal of Financial Economics, 2018, vol. 128, issue 1, 38-65

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.

Keywords: Lotteries; Gambling; Financial innovation; Cumulative prospect theory; Callable bull/bear contract (CBBC) (search for similar items in EconPapers)
JEL-codes: D03 D81 G12 G13 G23 (search for similar items in EconPapers)
Date: 2018
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