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

The Louis Harris 1976 Survey |23~ of options users is more detailed than the Philadelphia Stock Exchange Survey |32~, although it is not as recent. The Louis Harris Survey |23~ found that covered calls are particularly attractive to older investors who consider current income an important investment objective. Sixty-eight percent of the over-50 age group were selling covered calls, while only 49% of the under-50 group did so. Forty-four percent of the over-50 group rated current income as very important, while only 33% of the under-50 group did so |23, p. 10~.

We hasten to note that the data of the Louis Harris Survey are open to several interpretations and that we consider them useful for the formation of testable hypotheses but not for significant tests of these hypotheses. For example, one of the hypotheses that we will present later relates to investors who are consuming from their portfolios. While it is likely that a higher proportion of people in the over-50 age group are consuming from their portfolios than in the under-50 age group, classification by age group might well be different from classification by the rate of consumption from one's portfolio.

The Louis Harris Survey |23~ indicates that sellers of covered calls prefer full coverage (i.e., hedge ratio of one) over partial coverage. Fifty-six percent of sellers sold fully covered calls while only 19% sold partially covered calls |23, p. 108~. This Louis Harris finding is supported by Merton, Scholes, and Gladstein |27, p. 200~ who noted that, according to the CBOE, only 15% (approximately) of all options written are uncovered.

Finally, the Louis Harris Survey indicates that sellers of covered calls prefer out-of-the-money calls over in-the-money calls. Four times as many covered call positions were constructed with out-of-the-money calls as with in-the-money calls |23, pp. 142, 143~.

We suggest that these characteristics of investor preference are not independent and that investors in covered calls belong to two overlapping clienteles, one consisting of investors who are highly risk-averse in gains and highly risk-seeking in losses, and the other consisting of investors who consume from their portfolios. We begin our discussion with prospect theory and the attraction of covered calls to the clientele of investors who are highly risk-averse in gains and highly risk-seeking in losses.

II. Prospect Theory and Mental Accounts

The best portfolio of financial products maximizes an objective function, such as expected utility. Investors' objective function in prospect theory differs from its standard counterpart in several ways. Prospect theory investors evaluate their choices in terms of the potential gains and losses relative to some reference point |Rho~, while standard investors focus only on the net cash flow x. Moreover, while standard investors are always risk-averse, prospect theory investors have an S-shaped value function v(x - |Rho~) over gains and losses which displays concavity (risk-aversion) in the domain of gains and convexity (risk-seeking) in the domain of losses.(4)