Neglected Risk in Financial Innovation: Evidence from Structured Product Counterparty Exposure

We investigate the compensation of counterparty exposure in the prices of structured products. Our analysis reveals that product issuers did not compensate retail investors for counterparty exposure before the Lehman default. Post‐Lehman, retail prices have no longer neglected this risk. We also mea...

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Bibliographic Details
Published in:European financial management : the journal of the European Financial Management Association 2021-03, Vol.27 (2), p.287-325
Main Authors: Arnold, Marc, Schuette, Dustin, Wagner, Alexander
Format: Article
Language:English
Subjects:
Attention
Compensation
counterparty risk
Credit risk
Innovations
investor attention
neglected risk
Prices
structured products
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Summary:We investigate the compensation of counterparty exposure in the prices of structured products. Our analysis reveals that product issuers did not compensate retail investors for counterparty exposure before the Lehman default. Post‐Lehman, retail prices have no longer neglected this risk. We also measure retail investor attention towards issuer credit risk. For a given level of issuer credit risk, counterparty exposure is compensated more when attention is higher. Furthermore, issuers tend to construct products with larger counterparty exposure. Overall, our results shed light on the conditions under which financial engineering generates neglected risk.
ISSN:1354-7798
1468-036X
DOI:10.1111/eufm.12281