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Can utility optimization explain the demand for structured investment products?


Hens, Thorsten; Rieger, Marc Oliver (2014). Can utility optimization explain the demand for structured investment products? Quantitative Finance, 14(4):673-681.

Abstract

In this paper, we first show that for classical rational investors with correct beliefs and constant absolute or constant relative risk aversion, the utility gains from structured products over and above a portfolio consisting of the risk-free asset and the market portfolio are typically much smaller than their fees. This result holds irrespectively of whether the investors can continuously trade the risk-free asset and the market portfolio at no costs or whether they can just buy the assets and hold them to maturity of the structured product. However, when considering behavioural utility functions, such as prospect theory, or investors with incorrect beliefs (arising from probability weighting or probability misestimation), the utility gain can be sizable.

Abstract

In this paper, we first show that for classical rational investors with correct beliefs and constant absolute or constant relative risk aversion, the utility gains from structured products over and above a portfolio consisting of the risk-free asset and the market portfolio are typically much smaller than their fees. This result holds irrespectively of whether the investors can continuously trade the risk-free asset and the market portfolio at no costs or whether they can just buy the assets and hold them to maturity of the structured product. However, when considering behavioural utility functions, such as prospect theory, or investors with incorrect beliefs (arising from probability weighting or probability misestimation), the utility gain can be sizable.

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7 citations in Web of Science®
10 citations in Scopus®
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Additional indexing

Item Type:Journal Article, refereed, original work
Communities & Collections:03 Faculty of Economics > Department of Banking and Finance
Dewey Decimal Classification:330 Economics
Language:English
Date:30 January 2014
Deposited On:15 Apr 2014 12:23
Last Modified:05 Apr 2016 17:49
Publisher:Taylor & Francis
ISSN:1469-7688
Additional Information:This is an Author's Accepted Manuscript of an article published in Quantitative Finance, Volume 14, Issue 4, 2014. Copyright Taylor & Francis, available online at: http://www.tandfonline.com/10.1080/14697688.2013.823512
Publisher DOI:https://doi.org/10.1080/14697688.2013.823512
Other Identification Number:merlin-id:9161

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