The anchoring bias is a well known phenomenon in behavioural finance. As Tversky and Kahneman described it long ago(Amos Tversky and Daniel Kahneman (1974), “Judgment under Uncertainty: Heuristics and Biases”, Science, New Series, 185(4157), pp. 1124-1131):
In many situations,people make estimates by starting from an initial value that is adjusted to yield the final answer. … adjustments are typically insufficient. That is, different starting points yield different estimates, which are biased toward the initial values. We call this phenomenon anchoring.
Milind Kulkarni from FinIQ, a leading structured products solution provider gave me some information on an interesting regulatory measure by the Central Bank of Taiwan that exploits this behavioural bias to protect retail investors. Though he could not find an official English language text of the regulation, his colleague was able to provide a translation of the Chinese text:
When a bank buys an option from the client (to create yield enhancement) which is collateralized by client’s deposit which happens in to be the call currency with matching notional amount, in the event of the option exercise by the bank the client’s deposit (in call currency) will be retained (bought) by the bank and the alternate (put) currency will be repaid to the client at the strike rate, leading to potential capital loss to the client, such loss should not be more than 30% of the capital at any cost.
This means that the bank must sell a 70% out of the money call option back to the client to create such an airbag type protection against extreme capital loss. In short client sells a regular near ATM call option to the bank and buys back a deep OTM call option from the bank.
The interesting part of this regulation is that it does not rule out short term toxic products in which the retail investor’s annualized rate of return is hugely negative. If you lose 30% every month, you can lose practically everything pretty quickly. Even products that have a maturity of several months or even a year do not need to produce potential losses of 30% to create meaningful yield enhancement. On the other end of the scale, some of the most toxic products do not produce capital losses at all. Consider for example, some of the highly toxic principal protected Power Reverse Dual Currency (PRDC) notes that suddenly became 30 year near-zero coupon bonds when the yen moved sharply during the global financial crisis. The present value loss can be huge even if the principal is fully protected.
The practical effect of the Taiwanese regulation is not therefore so much economic as behavioural. When the product is structured with a 30% airbag, the structure draws the investor’s attention to the potential loss of 30%. Of course, investors know that the 30% loss is extremely unlikely, but 30% is now the anchor from which an adjustment is made to estimate the likely loss. This probably leads to an overestimate of the true loss. In the absence of the airbag, the bank probably tries to deflect the investor’s attention away from possible losses. The smart investor would of course take the bank’s sales pitch with a pinch of salt. But now the anchor is zero loss and insufficient adjustment from this anchor leads to an underestimate of potential losses.