Complex Securities

This paper proposes a dynamic equilibrium model to study the implications of the complexity of financial securities for investor behavior, asset prices, and welfare. The key assumption is that, unlike fund managers, non-professional investors cannot directly observe complex securities’ payoffs. In equilibrium, fund managers overinvest in complex securities as these potentially allow them to inflate investors’ expectations about their funds’ performance, thereby attracting more capital and thus more fees. This is so even though investors are not fooled in equilibrium. Overinvestment in complex securities drives up their price, leading to a “complexity premium” and a social welfare loss. The complexity premium creates incentives for “quants” to complexify simple securities. The supply of complex securities by quants is inverse-U shaped over time. I am extremely grateful to my supervisors Margaret Bray and Dimitri Vayanos for their continuous support and encouragement. The advice and guidance from Denis Gromb have been invaluable. For helpful comments, I wish to thank Ulf Axelson, Markus Brunnermeier, Amil Dasgupta, Bernard Dumas, Vincent Fardeau, Daniel Ferreira, Antonio Guarino, Stéphane Guibaud, Christian Julliard, Péter Kondor, Steven Monahan, Joel Peress, Astrid Schornick, Timothy Van Zandt, Kostas Zachariadis, as well as seminar participants at London School of Economics and INSEAD. Financial support from the Paul Woolley Centre for the Study of Capital Market Dysfunctionality at LSE is gratefully acknowledged. All errors and omissions are my own. Department of Economics and Financial Markets Group, London School of Economics, Houghton Street, London WC2A 2AE, UK. Email: [email protected]