Demand of structured products in a prospect utility frameworkUtility increase from capital protected index linked products

摘要

PURPOSE OF THE STUDYThis study examines the behavioral factors driving the demand for structured products (SP) and the utility implications for investors using these products, assuming that preference are defined by Kahneman and Tversky’s prospect utility framework. Based on this framework I will test how the utility of an economic agent is affected by adding SPs in to his portfolio. This thesis has two main research questions; should there exist a demand for SPs and whether consumers are better off using these products. A simple capital protected stock index linked note, the most common product category in Finland, is tested against an optimal two fund portfolio to determine the potential utility gain. I will also interview several professional engaged in the design and marketing of SPs to see whether the theoretical findings of my tests fit with the real world experience of the professionals.DATA AND METHODOLOGYTo test for the utility implications of SPs I will simulate the expected return distribution of a capital protected SP and an optimal two fund portfolio using the monthly returns on the MSCI World index and US treasury bonds from 1970-2011. Due to the potential for non-representativeness I will also vary these distributions to make sure that the same conclusions would hold with other datasets.To define revealed preferences I will use utility function parameters defined by Tversky and Kahneman (1992). The implications of expected utility being the true form of normative preference will also be tested using consumption based CAPM, with parameters defined by Mehra and Prescott (1985) and Mankiw & Zeldes’ (1991). I will also analyze the impact of different factors of the prospect utility framework by changing the function parameters to understand the precise factors driving the demand of SPs. RESULTSThe results show that, in a prospect utility framework, there is a clear addition in utility in certainty equivalent return terms. This addition even after costs is large enough to explain the demand towards SPs. This utility addition is mainly driven by a combination of loss aversion and the use of subjective probabilities, which are both components of the prospect utility framework. On the other hand Expected utility and prospect utility with true probabilities is only slightly increased compared to an optimal two-fund portfolio, this increase is not enough to outweigh the structuring costs of SPs. This leads us to believe that these products can have a utility decreasing effect for economic agents with low cost optimal portfolios as the alternative investment asset.