Behavioral aspects of the design and marketing of financial products - Security Design Special Issue

Financial Management (Financial Management Association), Summer, 1993 by Hersh Shefrin, Meir Statman

A. Hypotheses

We offer three additional hypotheses:

(i) There is a positive correlation between the use of covered calls and the rate of consumption from investors' portfolios.

(ii) There is a positive correlation between the use of covered calls and the dividend yields of investors' portfolios.

(iii) Covered calls are more likely to be constructed with dividend-paying stocks than with stocks paying no dividends.

V. Security Design Beyond Covered Calls

We have used covered calls as a vehicle for the exposition of three elements of a behavioral framework for the design and marketing of financial products. But the importance of the behavioral framework products extends much beyond covered calls. We mention here a few examples.

We have already noted that dividend-paying stocks are designed to appeal to a clientele of investors who separate cash flows into downside protected dividends and upside potential capital gains. Moreover, we argue that the feature that embeds "information content" into dividend changes is the preference for dividends of this clientele. Specifically, dividends have information content because managers set dividend policy with the knowledge that a cut in dividends will anger investors who rely on dividends as a downside protected account. Thus, managers cut dividends only as a last resort, when losses have occurred and are likely to continue (see DeAngelo, DeAngelo, and Skinner |11~). From this perspective, the signalling role of dividends is seen as a by-product of security design. This perspective is quite different from the common perspective in which dividends are designed primarily as a signalling device or the perspective where dividend payments are designed to discipline managers by forcing them to raise money in capital markets.

British premium bonds are another example of a security where cash flows are separated into "downside protected" and "upside potential" mental accounts. In this case, the bond's principal is in the downside protected account and a lottery is in the upside potential account. As Lohr |22~ describes:

The premium bonds pay no interest, but randomly selected bondholders receive monthly prizes ranging from |pounds~50 to |pounds~250,000, or about $77.50 to $387,500. "The word 'lottery' would never pass from my lips," Mr. Dodsworth explained. |22, p. C1~

Lee Cole, the Options Marketing Manager at Merrill Lynch is not likely to be surprised by the popularity of premium bonds. He observed in 1983 that many investors who held large balances in the Merrill Lynch Cash Management Account (CMA), a money market fund, used the CMA interest to buy call options. Notably, he designed LYONs as a security which would reflect the downside protection of a money market fund with the upside potential of options. LYONs are zero-coupon, convertible, callable and putable bonds. McConnell and Schwartz's |26~ description of the origin of LYONs illustrates the importance of designing securities with knowledge of the mental accounting characteristics of the target clientele: