Journal of Banking & Finance 31 (2007) 827–844

www.elsevier.com/locate/jbf

Retail banking and behavioral financial

engineering: The case of structured products
1
Wolfgang Breuer *, Achim Perst
RWTH Aachen University, Department of Finance, Templergraben 64, 52056 Aachen, Germany

Received 22 June 2005; accepted 8 June 2006

Available online 12 October 2006

Abstract

We apply cumulative prospect theory and hedonic framing to evaluate discount reverse convert-
ibles (DRCs) and reverse convertible bonds (RCBs) as important examples of structured products
from a boundedly rational investor’s point of view. While common expected utility theory would
also conclude that DRCs and RCBs are of interest to investors with moderate return expectations
and underestimated stock return volatility, that theory would overestimate the market success of
DRCs and underestimate that of RCBs in comparison to a situation with bounded rationality.
Hedonic framing and relatively low subjectively felt competence levels of investors are decisive for
the demand for RCBs.
Ó 2006 Elsevier B.V. All rights reserved.

JEL classification: G31; G32; G35

Keywords: Behavioral corporate finance; Behavioral finance; Financial engineering; Structured products

1. Introduction

One of the core tasks of investment banking is the constant search for opportunities to
create new financial instruments. Typically, this task is fulfilled by innovatively combining
already existing components to form new financial instruments. By combining a set of

*
Corresponding author. Tel.: +49 241 8093539; fax: +49 241 8092163.
E-mail addresses: wolfgang.breuer@rwth-aachen.de (W. Breuer), achim.perst@rwth-aachen.de (A. Perst).
1
Tel.: +49 241 8094774; fax: +49 241 8092163.

0378-4266/$ - see front matter Ó 2006 Elsevier B.V. All rights reserved.
doi:10.1016/j.jbankfin.2006.06.011
828 W. Breuer, A. Perst / Journal of Banking & Finance 31 (2007) 827–844

elementary components, it is possible to cater to the special needs of individual groups of

customers. This process is called ‘‘financial engineering’’, as investment bankers act simi-
larly to engineers or natural scientists when planning and creating complex financial inno-
vations, on the basis of some elementary building blocks, in order to meet their customers’
needs.
One of the most prominent groups of newly introduced financial instruments resulting
from such financial engineering is termed ‘‘structured products’’. These are combinations
of derivatives and underlying financial instruments which exhibit structures with special
risk/return profiles that may not be otherwise attainable on the capital market without sig-
nificant transaction costs being incurred – at least for private investors (see, e.g., Das,
2000). Discount reverse convertibles (DRCs, henceforth) and reverse convertible bonds
(RCBs, henceforth) are important examples of structured products. DRCs and RCBs
can be interpreted as a combination of a zero bond or a coupon bond plus a short position
in put options on stocks.
While the creation of new financial instruments of this kind is not too difficult, their
market success depends on the costs of their reconstruction for the issuer and the benefits
they offer to potential buyers. Certainly, for complex financial instruments like structured
products, there is a special need for a quantification of these costs and benefits. Financial
engineering thus comprises two quantitative subroutines. First, investment banks have to
calculate the costs of creating a certain structured product as the outcome of the combi-
nation of several single modules. This is typically done with the help of arbitrage-theoret-
ical tools for perfect capital markets, as investment banks can be considered as acting on
capital markets that are near to perfection.
Second, however, one has to evaluate a customer’s possible utility gains when he or she
buys a certain financial product, whereby it is necessary to abstract from a perfect capital
market – at least in the case of retail customers – because these customers do not have the
same unhampered market access as investment banks do. Moreover, there would other-
wise indeed be no need for any financial innovation at all, as we are told by the celebrated
irrelevance theorem introduced by Modigliani and Miller (1958).
One straightforward idea would be to apply expected utility theory based on the axioms
of rational decision making, as introduced by von Neumann and Morgenstern (1944) in
order to assess the utility effects of new financial products. However, ever since Allais pub-
lished his seminal work in 1953, there have been practically innumerable contributions, all
pointing out that real-life human decision behavior is not governed by such rational axi-
oms. In fact, even the evaluation of simple stock holdings by expected utility theory is
troubled by a problem known as the ‘‘equity premium puzzle’’, which describes the fact
that real-life risk premia are far higher than expected utility theory would suggest (see,
e.g., Mehra and Prescott, 1985). Recent work on the equity premium puzzle, like that
of Bernartzi and Thaler (1995), Barberis et al. (2001) and Barberis and Huang (2005),
therefore tries to exploit the findings of the (cumulative) prospect theory suggested by
Kahneman and Tversky (1979) and Tversky and Kahneman (1992). This alternative
behavioral decision theory seems to be one of the most promising attempts to realistically
describe many aspects of actual human decision making. With individuals’ value functions
being defined in wealth changes, instead of absolute wealth levels, and exhibiting loss aver-
sion as well as the assumption of overweighting extremely low and underweighting extre-
mely high probabilities, the (cumulative) prospect theory was originally designed for the
subjective evaluation of lotteries as the typical form of uncertain prospects. However, this
 W. Breuer, A. Perst / Journal of Banking & Finance 31 (2007) 827–844 829

theory can also be used to enhance our understanding of the equity premium puzzle, since
uncertain returns of financial instruments are themselves essentially nothing more than a –
possibly rather complex – lottery (see Barberis and Huang, 2005). We will follow this path
by applying the cumulative prospect theory, in combination with arbitrage theory, to price
and to evaluate DRCs and RCBs as examples of structured products. According to Glaser
(2001), we will use the term ‘‘behavioral financial engineering’’ to designate this specific
approach in the more general field of behavioral finance.
In order to contribute to the theory of behavioral finance by examining in detail aspects
of optimal pricing and product design, with regard to DRCs and RCBs as important
examples of structured products, we build on Shefrin and Statman (1993) and Glaser
(2001). Shefrin and Statman (1993) seem to have been the first to apply the idea of com-
bining concepts of arbitrage-theory and behavioral finance when examining a covered-call
position which consists of a combination of a stock and a short position in corresponding
call options and thus is – in principle – equivalent to a DRC. However, Shefrin and Stat-
man compared this position only with a direct stock holding. We extend their analysis by
accounting for the possibility of buying a riskless asset and RCBs as further alternatives.
Unfortunately, for the typical case of power value functions, in a one-period binomial
framework, as utilized by Shefrin and Statman, DRCs could never be preferred by indi-
viduals to both the sole purchase of stocks and riskless lending.2 We therefore have to
extend the analysis to a multi-period binomial framework.
Moreover, we must introduce a new kind of hedonic framing rule in place of that ini-
tially suggested by Thaler (1985) in connection with the handling of different mental
accounts – as described by Thaler (1980) and Tversky and Kahneman (1981). According
to the original hedonic framing rule, two distinct certain payments will only be viewed as
one single payment (integration) if this leads to a higher subjective value than the separate
evaluation of both payments (segregation) would. Our extension of this basic concept
explicitly accounts for the possible integration of uncertain prospects with certain ones
and makes it possible to evaluate particularly RCBs in a concise way. Finally, allowing
for the variation of central parameters of the cumulative prospect theory, we can take into
account recent findings of Kilka and Weber (2001) regarding the subjectively felt compe-
tence of individuals on their decision making.
Our main results are the following: first, expected utility theory and cumulative pros-
pect theory come to the same qualitative conclusion that DRCs and RCBs benefit from
low volatility estimates and medium-level return expectation estimates by investors. Actu-
ally, this is not too surprising, as investors who purchase DRCs or RCBs are effectively
taking a short position in stock options and DRCs and RCBs are competing with the
direct holding of stocks. In that respect, such qualitative findings should be expected for
any reasonable theory of human decision making. In the same way, analyses of the welfare
effects of direct stock holdings show the same qualitative results for both expected utility
theory and cumulative prospect theory: they both find positive risk premia. However,
according to the literature on the equity premium puzzle, quantitative outcomes differ con-
siderably, as resulting risk premia are significantly higher for boundedly than for fully
rational investors. The same holds true in an analogous way for our analysis of DRCs.
These are generally much more attractive for fully rational individuals than they are for

2
The proof of this statement is available from the authors upon request.
830 W. Breuer, A. Perst / Journal of Banking & Finance 31 (2007) 827–844

boundedly rational ones. We show that this result is mainly a consequence of the over-
weighting of small probabilities, which implies skewness preferences and thus makes the
holding of short option positions less attractive. Loss aversion, in contrast, only plays a
minor role in the explanation of this finding.
Second, the demand for RCBs by individual investors can only be understood against
the background of hedonic framing. Without hedonic framing, there is hardly any need for
RCBs, as they are simply a combination of a DRC and riskless lending, so that, for fully
rational investors, either of these alternatives will generally be better than their holding an
RCB. Third, the demand for structured products depends on the subjectively felt compe-
tence level of private investors, and RCBs in particular seem to become, ceteris paribus,
more attractive for individuals with smaller competence levels. This is because lower com-
petence levels reduce the desirability of uncertain prospects, so that differences in subjec-
tive evaluation of certain and uncertain prospects become more relevant, thus leading to a
greater importance of the hedonic framing rule. Fourthly, for our numerical analysis, the
subjectively felt competence level of possible customers turns out to be more relevant for
the market success of DRCs and RCBs than even the optimization of the issuance price
and, especially, than the redemption value or periodical interest payments connected with
these structured products.
Obviously, our approach can be used to derive recommendations for the adequate
product design regarding DRCs and RCBs. Our findings imply that issuers of DRCs
and RCBs should prefer blue-chip stocks as underlyings, since the volatility estimate of
these tends to be relatively moderate. Moreover, in particular with respect to the sale of
RCBs, banks should aim at those customers who do not feel too competent, as this renders
RCBs, ceteris paribus, more attractive. In addition, issuers of DRCs and RCBs may over-
estimate the market potential of these structured products when not accounting for indi-
viduals’ bounded rationality. Our approach can easily be applied to other financial
products and, thus, might generally help investment banks to better understand, design,
and even price financial innovations.
The rest of our paper is organized as follows: Section 2 presents the basics of the cumu-
lative prospect theory and the hedonic framing rule. In Section 3, we introduce DRCs and
RCBs as examples of structured products and we present their arbitrage-theoretical valu-
ation in the basic capital market setting introduced by Black and Scholes (1973). Section 4
presents the main results of our paper described above by contrasting the subjective eval-
uation of DRCs and RCBs for both fully rational and boundedly rational individuals. Sec-
tion 5 concludes.

2. Subjective value functions, probability weighting functions, and mental accounting

The original – as well as the cumulative – prospect theory is based on the subjective
evaluation of so-called ‘‘prospects’’. With a finite set S = {s1, . . ., sN} of potential future
states of nature, a prospect DX is a vector ((Dx1, p1), (Dx2, p2), . . ., (DxN, pN)) of pairs
(Dxi, pi), i = 1, . . ., N (see Schmeidler (1989) for the case of infinitely many outcomes).
For convenience reasons, we assume Dxi 6 Dxj for i < j, i, j = 1, . . ., N, with Dxi 6 0
(i = 1, . . ., k) and Dxi > 0 (i = k + 1, . . ., N). Prospects assign to any possible state si of nat-
ure a subjective probability pi and an outcome Dxi which is defined relative to a certain
reference point x(R), i.e., with xi as the absolute outcome, we have Dxi:= xi  x(R). With
 W. Breuer, A. Perst / Journal of Banking & Finance 31 (2007) 827–844 831

decision weights pi and a value function v(Dxi), an investor’s subjective evaluation CPT for
a prospect DX, according to the cumulative prospect theory, is
X
N
CPT½DX  ¼ pi  vðDxi Þ: ð1Þ
i¼1

In contrast to the utility function u(xi) of traditional expected utility theory, v(Dxi) is
based on relative outcomes and its curvature is convex in the range of losses and concave
in the range of gains with a ‘‘kink’’ at Dx = 0, so that it deviates from most common types
of utility functions. According to Tversky and Kahneman (1992), we have
(
ðDxÞa ; Dx P 0;
vðDxÞ ¼ b ð2Þ
k  ðDxÞ ; Dx < 0

with a  b  0.88 and a loss aversion parameter k  2.25. For the sake of simplicity, we
assume decision-makers’ reference points to be identical to their initial wealth W0. W0
can be arbitrarily chosen without affecting the relative ranking of different investment
alternatives because of the specific shape of the investor’s value function according to
(2) and the fact that the payoff functions of all financial instruments under consideration
are homogeneous of degree 1 with respect to the amount invested in them.
Moreover, subjective values v(Dxi) are not multiplied by probabilities pi but by decision
weights pi that are computed on the basis of probability weights w (for losses Dx < 0) and
w+ (for gains Dx > 0):
 
pi :¼ w ðp1 þ    þ pi Þ  w ðp1 þ    þ pi1 Þ ði ¼ 1; . . . ; kÞ;
pi :¼ ð3Þ
pþ þ þ
i :¼ w ðp i þ . . . þ p N Þ  w ðp iþ1 þ . . . þ p N Þ ði ¼ k þ 1; . . . ; N Þ:

The introduction of probability weights makes it possible to allow for certain empirical
findings which are known as the probability (or possibility) effect and the certainty effect
(see Kahneman and Tversky, 1979) and which capture the decision-maker’s peculiarity of
overweighting the tails of probability distributions. According to a suggestion by Latti-
more et al. (1992), we may write
8 þ
>
> þ dþ  p c
>
< w ðpÞ :¼ cþ
; Dx > 0;
d  pc dþ  pcþ þ ð1  pÞ
wd;c ðpÞ :¼ c :¼ c
ð4Þ
d  pc þ ð1  pÞ >
> d 
 p
> w ðpÞ :¼
: 
Dx < 0:
c ;
d  pc þ ð1  pÞ
Parameters d and c may be different for w+ and w and are ‘‘responsible’’ for different
features of the probability weighting function wd,c. While c primarily controls the so-called
‘‘discriminability’’, ‘‘attractiveness’’ is determined in the first instance by d, whereby dis-
criminability means the intensity with which individuals distinguish among different prob-
abilities, and can be characterized by the slope of the probability weighting function for
medium-level probabilities. In contrast, attractiveness is described by the absolute values
of the probability weighting function, as this shows the extent to which an individual
appreciates different probabilities (for more details, see Gonzales and Wu, 1999).
For decision making under conditions of risk, where all probabilities are given, each
specification of these parameters reflects a specific attitude towards risk. According to
Abdellaoui (2000), such an ‘‘average’’ attitude can be specified as d+ = 0.65 and
832 W. Breuer, A. Perst / Journal of Banking & Finance 31 (2007) 827–844

c+ = 0.60 as well as d = 0.84 and c = 0.65 (for other empirical studies regarding real-life
values of parameters d and c, see Tversky and Fox, 1995; Wu and Gonzales, 1996; and
Bleichrodt and Pinto, 2000). In a decision situation under uncertainty, probabilities are
no longer exogenously given and, thus, have to be first estimated by the decision-maker.
Since Ellsberg (1961), it has been well-known that decision making based on such subjec-
tive probabilities depends, to some extent, on the decision-maker’s confidence in his or her
subjective probability judgements (see, also, Heath and Tversky, 1991). Modelling this so-
called ‘‘attitude towards ambiguity’’, Kilka and Weber (2001) have claimed that an
individual’s perceived competence with respect to the source of uncertainty positively
influences the parameters d and c, as his or her confidence in his or her probability assess-
ments, ceteris paribus, increases with a higher competence level. According to Abdellaoui
et al. (2005), typical parameter values for decisions under uncertainty are d+ = 0.975 and
c+ = 0.832 as well as d = 1.345 and c = 0.842, thus indicating some kind of ‘‘over-com-
petence’’ feelings in situations with ambiguity compared to a decision under pure risk. In
our numerical analysis of Section 4, we therefore will allow for both the parameter values
of Abdellaoui (2000) and Abdellaoui et al. (2005), which can be interpreted as situations
with different levels of subjectively felt competence of investors.
Another prominent feature of the human decision process occurs when multiple out-
comes are involved. As pointed out by Thaler (1980) and Tversky and Kahneman
(1981), people may keep different ‘‘mental accounts’’ for different types of outcomes.
For example, investors distinguish between dividend yields, which are normally used for
consumption, and gains from stock price movements, which are usually put aside. When
combining these accounts to obtain the overall result, people, typically, do not simply add
up all monetary outcomes, such as an expected utility maximizing agent would do, but
rather, according to Thaler (1985), they use a so-called ‘‘hedonic frame’’ in which the com-
bination of the outcomes appears best possible. More formally, according to Thaler
(1999), if the operator ‘‘&’’ denotes the combination of two sure outcomes Dx and Dy,
the hedonic frame is described by the following rule:
vðDx&DyÞ :¼ max fvðDx þ DyÞ; vðDxÞ þ vðDyÞg: ð5Þ

Outcomes Dx and Dy are integrated (v(Dx + Dy)) or segregated (v(Dx) + v(Dy)),

depending on what leads to the highest possible overall CPT value.
For an uncertain prospect DX = ((Dx1, p1), (Dx2, p2), . . ., (DxN, pN)), an extension of this
rule is necessary:
!
XN XN
CPT½DX &Dy :¼ pi  vðDxi &DyÞ þ 1  pi  vð0&DyÞ; ð6Þ
i¼1 i¼1

Obviously, the last summand on the right-hand side of (6) needs some explanation. In
fact, without this term, similar problems of unreasonable decision behavior arise, as in the
original prospect theory that induced Kahneman and Tversky (1979) to formulate a spe-
cial segregation rule for riskless components in their editing phase. First, without this term
we would not have the quite plausible equality CPT[DX + Dy] = v(Dy) in the case of
Dxi ! 0 (for all i = 1, . . ., N). As a consequence, the subjective value of a certain outcome
Dy, to which an uncertain prospect DX with arbitrarily small possible outcomes near to
zero is added, could be significantly different from the subjective evaluation of Dy alone.
Second, without the last summand on the right-hand side of (6), situations with
 W. Breuer, A. Perst / Journal of Banking & Finance 31 (2007) 827–844 833

v(Dx&Dy)
PN = v(Dx) + v(Dy) for all i = 1, . . ., N yield CPT½DX &Dy :¼ CPT½DX þ
i¼1 pi  vðDyÞ and not, as one would reasonably expect, CPT[DX&Dy] = CPT[DX] +
v(Dy).
In addition, the discontinuity implied by the omission of the last summand in (6) would
create possibilities for P(almost riskless) gains for unboundedly rational individuals. For
example, in the case of Ni¼1 pi < 1, one could sell Dy at v(Dy)
P to boundedly rational inves-
tors on the one side and buy from some others DX + Dy at Ni¼1 pi  vðDyÞ < vðDyÞ with DX
being identical
PN to approximately 0 with probability 1, on the other side. Moreover, in the
case of i¼1 pi < 1, one could sell DX and Dy separately to different boundedly rational
investors at P CPT[DX] + v(Dy) on the one side and buy from some others DX + Dy at
N
CPT½DX  þ i¼1 pi  vðDyÞ < CPT½DX  þ vðDyÞ, on the other side. Since such arbitrage
operations seem rather implausible and are, in fact, not documented in the literature,
we suggest (6) as a generalization of (5), so that both problems mentioned before are effec-
tively avoided. Against the theoretical background of this section, it is now possible to
evaluate different financial instruments from a boundedly rational investor’s point of view,
whereby we will contrast our results with those obtained for a fully rational investor with a
constant relative risk aversion of 1 or of 2, since empirical studies by, e.g., Arrow (1971)
and Friend and Blume (1975) hint at values for investors’ relative risk aversion of 1–2.

3. Discount reverse convertibles (DRCs) and reverse convertible bonds (RCBs) on perfect
capital markets

Particularly prior to the stock market crash in 2000, DRCs had been rather popular
financial products for private investors in Germany, while in other countries, e.g., in the
USA, these financial instruments had actually been prohibited.3 In fact, a DRC is the same
as a combination of a zero bond with a short position in m put options, each for one stock,
and with a total expiration price just amounting to the redemption value rv of the bond.
As a consequence of this special arrangement, the buyer of a DRC earns at the expiration
date t = T of his or her security just the minimum of the redemption value and the current
price m Æ sT of the m stocks, which could be delivered by exercising the m put options.
Without loss of generality, from now on, we assume m = 1, as this describes the typical
design of DRCs.
It is not difficult to determine the value of financial instruments of this kind on a perfect
capital market in equilibrium with continuous trading possibilities when applying the com-
mon option pricing theory according to Black and Scholes (1973). In the absence of div-
idend payments and with

drc0 as the price of the DRC at time t = 0,

zb0, s0, and po0 as the prices at t = 0 of the underlying zero bond, one stock and one put
option,
r0c as the (continuous) riskless interest rate,
rSc as the volatility of the future stock price which follows a lognormal distribution and
FND(Æ) as the cumulative distribution function of the standard normal distribution,

3
However, liquid yield option notes (LYONs), as created in 1985 by Merrill Lynch are in some ways
comparable to DRCs. For the features of LYONs, see, e.g., McConnell and Schwartz (1986). Moreover, covered-
call positions, as introduced above, are – under certain conditions – a perfect substitute for DRCs.
834 W. Breuer, A. Perst / Journal of Banking & Finance 31 (2007) 827–844

we have drc0 = zb0  po0, and

 pffiffiffiffi 
zb0 ¼ rv  expðr0c  T Þ; po0 ¼ expðr0c  T Þ  rv  F ND rSc  T  d ðT
rv
Þ
 s0
 F ND ðd ðT Þ
rv Þ; ð7Þ
ðT Þ lnðs0 =rvÞ þ ðr0c þ 0:5  r2Sc Þ  T
d rv :¼ pffiffiffiffi :
rSc  T

A rational issuer of DRCs will only accept issuance prices which are not smaller than
drc0. Certainly, the issuer will prefer any ceteris paribus increase in the issuance price. We
refer to the difference between issuance price ip and arbitrage free valuation drc0 as the
issuer’s absolute premium ap. The fraction ap/drc0 describes the relative premium rp.
In a similar way to DRCs, RCBs have been proven to be quite successful as well (see,
e.g., Beike, 2000). RCBs differ from DRCs insofar as the former offer additional periodical
interest payments to their buyers. At the time of maturity, the issuer of an RCB has the
right to pay a fixed amount of money or to deliver a certain number of a certain security
as a substitute. RCBs can thus be considered as a combination of DRCs and a set of zero
bonds with maturities at the dates of interest payments. Arbitrage-free evaluation implies
that the value of an RCB is the sum of the value of this set of zero bonds and the value of
the remaining DRC.
As DRCs and RCBs are identical to portfolios of zero bonds and a short position in put
options from a fully rational investor’s point of view, it is actually possible to evaluate
DRCs and RCBs on the basis of general option pricing theory – as presented, e.g., by Hull
(2005) – for almost arbitrarily more complex settings than the one assumed above. For an
example of this, see Wilkens and Röder (2003) for the evaluation of DRCs and RCBs in
the case of stochastic volatility. However, the main focus of our paper is not option pricing
theory, but the analysis of the interrelations between arbitrage-free and boundedly
rational valuation of structured products. For this reason, we will restrict ourselves to
the basic setting of option pricing.
Moreover, it is hardly possible to derive general analytical insights into the subjective
evaluation of financial instruments by applying the cumulative prospect theory. In what
follows, we will therefore strongly rely on numerical examinations. More precisely, we
consider a real-life DRC (ISIN code DE 000 359 196 2), as seen on 10/13/03 (the
announcement day of the intended issuance on 10/21/034), with redemption value €36
and maturity date 06/17/05. This DRC offers the issuer the right to pay 1:100 of the Ger-
man DAX30 index value instead of the redemption value at maturity, whereby, on 10/13/
03, a DAX30 value of 3538.39 could be observed, so that we have s0 = €35.3839.
A decision-maker who assumes the DAX30 index to be lognormally distributed and
estimates volatility of the DAX30 index on 10/13/03 as being that implied by an applica-
tion of the formula by Black and Scholes (1973) to a call option on the DAX30 with strike
price 3.600 and maturity date 06/17/05, arrives at rSc = 25.686%. With this volatility esti-
mation, an annual riskless interest rate of r0 = 2.6275% and a time to maturity of
T = 1.6783 years, we derive from drc0 = zb0  po0 and (7) drc0 = €30.30 as the ‘‘fair’’ price
of the DRC on 10/13/03. Since the actual issuance price was chosen as €30.79, the absolute

4
In what follows, we neglect the (quite small) difference between announcement date and issuance date.
 W. Breuer, A. Perst / Journal of Banking & Finance 31 (2007) 827–844 835

premium ap thus amounts to €0.49 and the relative one rp to about 1.62%. In what fol-
lows, we assume rSc = 25.686% to be the issuer’s volatility estimation.
Additionally, we consider a fictitious RCB with an announcement date 10/13/03 and an
expiration date 06/17/05, thus being identical to the DRC under consideration. The nom-
inal value of the RCB shall be €5000 and the issuer of this instrument is granted the right
to deliver 1.3888 times the value of the DAX30 index on the expiration date. He or she will
make use of this option for DAX30 index values below 5000/1.3888  3600, so that 3600
describes the ‘‘cap’’ of this RCB. Additionally, we assume that all interest payments to the
buyers of the RCB are due on 06/17/05 with a nominal interest of 9.86% p.a. and an inter-
est calculation for the whole period from 10/13/03 to 06/17/05 and, hence, T = 1.6783
years. Therefore, interest payments on 06/17/05 amount to 1.6783 Æ 0.0986 Æ 5000 
€827.40. Apparently, the RCB can be reproduced by the simultaneous purchase of
138.88 DRCs and a zero bond with a redemption value of €827.40, as this financial posi-
tion leads to the same payments on the expiration date as the original RCB does. The
overall fair value of the RCB in question thus coincides with its nominal value because
138.88 Æ 30.30 + 827.40/1.0262751.6783  €5000. In the next section, we will now turn to
the evaluation of RCBs and DRCs from an individual investor’s point of view.

4. DRCs and RCBs from an individual investor’s point of view

We start by considering an investor with an arbitrary initial wealth W0, who compares
three alternatives: an engagement solely in the DRC introduced above, an investment
solely in DAX30 stocks underlying the DRC and the sole purchase of the riskless asset,
whereby it is necessary to apply a discrete-space approximation in the spirit of Cox
et al. (1979) when evaluating different financial instruments by cumulative prospect theory,
since closed-form analytical solutions are not available for this problem as a consequence
of our distributional assumptions.5
For arbitrage-free valuation purposes, the expected continuous return of the DAX30
does not matter. However, this parameter may be relevant for a private investor with
no access to arbitrage opportunities. We therefore denote by lSc(e) the subjectively esti-
mated expected continuous return of the DAX30 as seen from a private investor’s point
of view, whereby we allow for values between 0.05 and 0.15. In the same way, rSc(e)
stands for the private investor’s subjective volatility estimate, which is not necessarily iden-
tical to the issuer’s volatility estimate rSc. For reasons which will become clearer later on,
we restrict ourselves to situations with 0.1 6 rSc(e) 6 0.25, while the issuer of the DRC
assumes rSc = 25.686% according to the calculated implied volatility.
Based on these assumptions, Fig. 1a–d present our first numerical results, whereby we
assume an absolute premium ap = 0 and consider a fully rational individual with a con-
stant relative risk aversion of 1 (Fig. 1a) and a boundedly rational one exhibiting a value
function according to Tversky and Kahneman (1992) and a probability weighting function
according to Abdellaoui (2000), with the latter representing a low subjectively felt compe-
tence level (Fig. 1b). Moreover, in order to analyze the causes of possible differences
between the two figures, we also consider the case of a boundedly rational investor with

5
More information on the approximation procedure and its precision is available from the authors upon
request.
836 W. Breuer, A. Perst / Journal of Banking & Finance 31 (2007) 827–844

Fig. 1. Subjective desirability of a DRC (gray) in comparison to a riskless investment (black) and a direct stock
engagement (white) depending on subjectively expected stock return lSc(e) and volatility rSc(e) with absolute
premium of 0 and different decision situations. Black areas of pairs of subjectively expected (continuous) stock
return lSc(e) and corresponding volatility rSc(e) by an investor are characterized by the superiority of a riskless
investment compared to the purchase of a discount reverse convertible (DRC) and a direct stock holding.
Correspondingly, white [gray] areas stand for combinations (lSc(e), rSc(e)) for which a direct stock investment [the
purchase of the DRC] is optimal. Thereby, the DRC is issued at its arbitrage-free price of €30.30 (with given
volatility assessment rSc = 25.686% by the fully rational issuer). Situation (a) corresponds to a fully rational
investor with constant relative risk aversion of 1, situations (b)–(d) characterize a boundedly rational investor
with (b) a probability weighting function according to Abdellaoui (2000) and a value function according to
Tversky and Kahneman (1992) with loss aversion parameter k = 2.25, while (c) ceteris paribus assumes a loss
aversion parameter k = 1 and (d) ceteris paribus assumes decision weights that are identical to probabilities.

general preferences according to Abdellaoui (2000), but ceteris paribus, a loss aversion
parameter k = 1, i.e., no loss aversion at all, (Fig. 1c) or decision weights pi = pi,
i = 1, . . ., N (Fig. 1d). The gray shaded areas in the l–r-space of Fig. 1 denote such param-
eter combinations (lSc(e), rSc(e)), which lead to the investor’s decision to purchase the
DRC, while the white areas stand for parameter values, which result in a direct investment
in the DAX30 itself. Finally, the black areas correspond to the superiority of a riskless
investment. Additional figures for the case of constant relative risk aversion of two and
boundedly rational investors with probability weighting functions according to Abdellaoui
et al. (2005) are available from the authors upon request, but do not lead to any additional
new insight. In particular, the qualitative findings are the same for both situations with a
fully rational investor according to (a) and a boundedly rational one according to (b).

Result 1. For fully as well as boundedly rational investors, the DRC can only be placed
successfully at medium-level expected stock returns because, for higher values of lSc(e), direct
stock holdings will be preferred. Moreover, high volatility estimates rSc(e) will reduce the
preference for the DRC compared to the riskless asset because of the short put position as
part of the overall DRC, whereby, in general, higher or lower expected returns must be
compensated for by a lower volatility estimate in order to assure the desirability of the DRC.

Certainly, Result 1 is not too surprising. In fact, any reasonable decision theory should
lead to the finding that stocks are preferred to DRCs for lSc(e) being high enough and risk-
less lending being preferable for high values of rSc(e). In the same way, one would expect
equilibrium risk premia for stock holdings to be positive, regardless of the theory of
human decision making under consideration. However, there might be relevant quantita-
tive differences. In particular, as suggested by Fig. 1, a DRC seems to be generally more
desirable for a fully rational investor than for a boundedly rational one. Fig. 1c and d
point out that, in fact, for this finding, the influence of probability weighting functions
is more pronounced than that of an investor’s loss aversion in order to explain the differ-
 W. Breuer, A. Perst / Journal of Banking & Finance 31 (2007) 827–844 837

ences between Fig. 1a and b. While missing loss aversion just increases the range of para-
meter values lSc(e) for which the direct holding of stocks is preferable, the overweighting of
small probabilities implies specific skewness preferences: since an investment in a DRC can
be interpreted as the combination of a stock holding combined with a short call option on
that stock, the resulting abandonment of high gains (with rather low probability) from
increasing stock prices will lead to quite high utility reductions for a boundedly rational
investor.
A situation with ap = 0 can be interpreted as the case of perfect competition among
banks, thus eroding any possibility to reap some profits from issuing structured products.
In fact, in such a situation, without the possibility of demanding excessive issuance prices
for structured products, there is no room for an effective wealth transfer from private
investors to investment banks. However, one can also examine situations where ap is (at
least temporarily) the bank’s decision variable. To this end, we consider the following sit-
uation: we continue to assume that investors only select among the alternatives of buying
either solely the DRC in question, the DAX30 or the riskless asset in the way described
above and assume, additionally, that the assessments with respect to parameters lSc(e)
and rSc(e) among these investors are uniformly distributed in the intervals [0.05, 0.15]
and [0.10, 0.25], respectively. Indeed, since the range of parameter values in question com-
prises all assessments that result in the possibility of positive premia ap when selling DRCs
and RCBs, and since the uniform distribution function is characterized by a constant value
of its density, extensions of these intervals would not affect the resulting optimal premia
and proportions of resulting expected bank profits. Moreover, we define W0,tot as the total
wealth equally distributed among all investors under consideration as well as f(ap) as the
fraction of all investors accepting a certain absolute premium ap. Then, we get

Result 2. The maximization of a bank’s expected profit P from the issuance of DRCs of the
kind under consideration with
W 0;tot  f ðapÞ f ðapÞ  ap
P :¼  ðdrc0 þ ap  drc0 Þ ¼ W 0;tot  ð8Þ
drc0 þ ap drc0 þ ap
leads to optimal values ap* and rp* for different situations according to Table 1, which comply
fairly well with typical real-life margin settings that range from about 1.5% to 3.5% (see, e.g.,
Wilkens et al., 2003, or Stoimenov and Wilkens, 2005). Moreover, optimal premia do not

Table 1
Optimal pricing of a DRC and corresponding expected bank profits for different situations
Situation (a) (b) (c) (d) (e) (f) (g)
ap* 0.9 0.6 0.8 0.8 1 0.9 0.8
rp* 2.97% 1.98% 2.64% 2.64% 3.30% 2.97% 2.64%
P/W0,tot 0.006869 0.001805 0.002042 0.005425 0.007680 0.003402 0.004025
Optimal absolute and relative premia for a DRC as well as corresponding expected profits (in €) for a bank per €
investors’ initial wealth for different situations: (a) a fully rational investor with constant relative risk aversion of
1, (b) a boundedly rational investor with a probability weighting function according to Abdellaoui (2000) and a
value function according to Tversky and Kahneman (1992) with loss aversion parameter k = 2.25, (c) as (b), but
without loss aversion (k = 1), (d) as in (b), but with decision weights that are identical to probabilities, (e) as (a),
but with constant relative risk aversion of 2, (f) as (b), but probability weights according to Abdellaoui et al.
(2005), (g) as (f), but without loss aversion. Investors’ expectations with respect to parameters lSc(e) and rSc(e) are
assumed to be uniformly distributed over the intervals [0.05, 0.15] and [0.10, 0.25] respectively.
838 W. Breuer, A. Perst / Journal of Banking & Finance 31 (2007) 827–844

vary much across different decision situations, a fact which seems to contradict the general
impression given by Fig. 1a and b. However, a bank’s expected profit per € of investors’ total
initial wealth W0,tot from the issuance of the DRCs in optimum, as described by P*/W0,tot, is
about two to four times higher for fully rational investors than it is for boundedly rational
ones. Moreover, the shift from a situation with boundedly rational investors according to
Abdellaoui (2000) (i.e., low competence levels) to those according to Abdellaoui et al.
(2005) (i.e., high competence levels) is of some relevance with lower competence levels reduc-
ing the desirability of DRCs, but resulting differences regarding P*/W0,tot are lower than
when switching from full rationality to bounded rationality.
According to Result 2, the precise specification of investor preferences seems to be of
minor importance only for optimal pricing decisions, but it is of high relevance for the esti-
mation of the market potential for the DRC DAX 30 under consideration. This assess-
ment could be severely misled by the simplifying assumption of rational investors who
are, in fact, only boundedly rational. It is in precisely this way that the approach of this
paper may help to enhance banks’ decisions on optimal security pricing.
Hence, our analysis apparently reveals the somewhat surprising result that DRCs are,
ceteris paribus, more attractive for rational investors than they are for only boundedly
rational ones. Actually, this result is in line with the findings with respect to the equity pre-
mium puzzle. On stock markets, boundedly rational investors act – on average – more
risk-aversely than fully rational ones, so that it does indeed seem plausible that the
DRC will, ceteris paribus, be preferred by fully rational investors more so than by bound-
edly rational ones because of its inherent short put option. Variations of competence levels
affect the desirability of DRCs as well (although only to a minor degree6) because, in par-
ticular, riskless lending becomes relatively more attractive in situations with lower compe-
tence levels.
This relevance of the explicit recognition of irrationalities is further confirmed if we
extend our analysis to the consideration of RCBs which, in contrast to DRCs, offer addi-
tional periodical interest payments to their buyers. Such RCBs have been proven to be
quite successful as well (see Beike, 2000) and this remarkable fact cannot be captured very
easily by traditional expected utility theory. As an RCB can usually be reproduced by the
simultaneous purchase of DRCs and zero bonds, it becomes immediately clear that risk-
neutral fully rational investors hardly decide to purchase an RCB: generally, either a
‘‘pure’’ DRC or a pure riskless investment will be assessed as preferable. Actually, the
same holds true for plausible values of a fully rational investor’s risk aversion, as is high-
lighted by Fig. 2a and b.

6
The influence of varying competence levels is even more limited, if one accounts for the fact that there is a
positive relationship between optimism and subjectively felt competence levels (see Kilka and Weber, 2000), as an
increase in return expectations ceteris paribus lowers the desirability of DRCs in comparison to a direct stock
holding. Moreover, it is possible to analyze the isolated impact of changes in either discriminability c or
attractiveness d on the desirability of DRCs. While increases in d adversely influence the evaluation of DRCs in
the same way as more optimistic return expectations do (i.e., the overall effect of an increase in d is mainly
determined by its impact in the domain of gains), increasing values for c, and thus a higher sensitivity of the
probability weighting function for medium-level probabilities, but a lower sensitivity for extremely low and
extremely high probabilities, reduce skewness preferences and thus render DRCs more advantageous. Further
details are available from the authors upon request.
 W. Breuer, A. Perst / Journal of Banking & Finance 31 (2007) 827–844 839

Fig. 2. Subjective desirability of a DRC (lighter gray) in comparison to a riskless investment (black), a direct
stock engagement (white), and an RCB (darker gray) depending on subjectively expected stock return lSc(e) and
volatility rSc(e) with absolute premium of 0 and different decision situations. Four alternative investments are
compared. Black [white, lighter gray, darker gray] areas of pairs of subjectively expected (continuous) stock
return lSc(e) and corresponding volatility rSc(e) by an investor are characterized by the superiority of a riskless
investment [a direct stock investment, the purchase of the discount reverse convertible (DRC), the purchase of the
reverse convertible bond (RCB)]. Situations (a) and (b) correspond to a fully rational investor with constant
relative risk aversion of 1 or 2, respectively, situations (c) to (e) characterize a boundedly rational investor, with a
probability weighting function according to Abdellaoui (2000) and a value function according to Tversky and
Kahneman (1992), who acts according to the hedonic framing rule (situation (c)), always segregates mental
accounts (situation (d)) or always integrates mental accounts (situation (e)). Situations (f) and (g) differ from (c)
by a loss aversion parameter of 1 or by the absence of a particular probability weighting function. Situation (h)
differs from situation (c) by the assumption of a probability weighting function according to Abdellaoui et al.
(2005).

In contrast, boundedly rational investors following the generalized hedonic framing

rule introduced in Section 2 will find RCBs far more attractive, as this combination of
a DRC and a zero bond might give rise to compound evaluations which exceed the sum
of the isolated subjective values of the DRC and the zero bond as a consequence of avoid-
ing subjectively felt losses from holding the DRC alone. This result is depicted in Fig. 2c to
e for a boundedly rational investor with a value function according to Tversky and Kahn-
eman (1992) and a probability weighting function according to Abdellaoui (2000): only in
the case of hedonic framing (Fig. 2c), do RCBs appear to be an interesting financial prod-
uct – even for boundedly rational investors – because, in situations with losses caused by
the DRC component of the RCB, an integrate consideration of these losses implies greater
CPT values than a segregate consideration does. With unconditional segregation (Fig. 2d),
RCBs would hardly be chosen by an investor. The same holds true in situations with
unconditional integration of mental accounts by boundedly rational investors (Fig. 2e),
as is precisely the case for expected utility maximization.
Moreover, the assessment of RCBs reacts quite sensitively when comparing decision sit-
uations with different subjectively felt competence levels (Fig. 2c and h). The intuition for
this result is that decreasing competence implies smaller values for attractiveness and dis-
criminability and thus leads to a relatively higher importance of certain interest payments,
840 W. Breuer, A. Perst / Journal of Banking & Finance 31 (2007) 827–844

which are here part of the overall RCB, making the RCB more advantageous in particular
in relation to a simple DRC.7
Finally, as in the case of the DRC, the application of a probability weighting function
turns out to be more important than the recognition of loss aversion in order to distinguish
between a situation with fully rational investors and only boundedly rational ones. In fact,
this outcome corresponds to the finding of a higher relevance of variations in competence
levels in the case of RCBs than in the case of DRCs, because a situation with pi = pi
(i = 1, . . ., N) results for d = c = 1 and can thus be interpreted as a situation with rather a
high level of subjectively felt competence. We summarize our findings in the following

Result 3. RCBs are far more attractive to boundedly rational investors than they are to fully
rational ones because, only in the former case is the hedonic framing rule in effect, thus
making an RCB as a combination of a DRC and riskless lending preferable to both single
components. Moreover, RCBs become, ceteris paribus, more attractive for a decreasing
investor’s subjectively felt competence, as for a reduced competence level, the riskless part of
overall payments to the buyer of an RCB becomes more relevant. The last finding also implies
that the desirability of RCBs crucially depends on the particular probability weighting
function suggested by the cumulative prospect theory, while an investor’s loss aversion is of
only minor importance.

Once again, Result 3 may lead to immediate practical applications. On the one hand,
issuers of RCBs should especially address retail customer groups who do not feel too com-
petent (e.g., by way of newspaper advertisements), as the desirability of an RCB increases
with decreasing competence. On the other hand, the issuer should select those underlying
stocks that are well understood by investors, as is typically the case for blue-chip stocks.
This corresponds to the necessity of rather low volatility estimates by potential buyers of
RCBs (and DRCs).
Moreover, a utilization of the advantages of the hedonic framing rule may imply the
issuance of RCBs with, ceteris paribus, quite high periodical interest payments. To exam-
ine this idea more precisely, we consider an investor who has only to choose among the
alternatives of buying either solely the RCB in question, the DAX30 or the riskless asset.
In order to complete our analysis, we additionally look at the same decision situation once
again but with the RCB being replaced by the DRC introduced above. Let the investors’
assessments with respect to parameters lSc(e) and rSc(e) be uniformly distributed in the
intervals [0.05, 0.15] and [0.10, 0.25], respectively. For the first situation, we consider
the same RCB as introduced in Section 3, but simultaneously optimize the absolute pre-
mium, the number of the DAX30 index to be delivered, the cap as well as the additional
interest payment for given identical fair value and nominal value of €5000 each. The prod-
uct of the cap and the number of the DAX30 index to be delivered thus remains constant

7
Available from the authors upon request, a more thorough analysis reveals that this finding is, in the first
instance, a consequence of the change in attractiveness d, which leads to the same consequences as changing
return expectations: higher competence levels that coincide with better return expectations will reduce the
desirability of an RCB even more and this effect increases if c is held constant and only d is altered. In contrast,
ceteris paribus increases of c improve the evaluation of the RCB in a similar way to that in the case of the DRC.
While the separate effects of increases in c and d due to higher competence levels in our numerical analysis are thus
identical for RCBs and DRCs, the resulting overall effect differs as a consequence of the additional riskless part of
the RCB payment pattern.
 W. Breuer, A. Perst / Journal of Banking & Finance 31 (2007) 827–844 841

Fig. 3. Expected relative gains from the issuance of DRCs or RCBs for different situations. Optimal redemption
values rv* (or optimal cap in the case of the RCB), absolute (ap*) and relative premia (rp*) for a DRC (a, b, and c)
or an RCB (d) as well as corresponding expected profits P*/W0,tot (in €) for a bank per € initial investors’ wealth
for different situations: (a) a boundedly rational investor with a probability weighting function according to
Abdellaoui (2000), (b) and (d) as (a), but a probability weighting function according to Abdellaoui et al. (2005),
(c) as (a), but with given redemption value of €36. Investors’ expectations with respect to parameters lSc(e) and
rSc(e) are assumed to be uniformly distributed over the intervals [0.05, 0.15] and [0.10, 0.25], respectively. In
situations (a) and (b) properties of a DRC, which competes with a direct stock holding and a riskless investment,
are optimized. In situation (d), the DRC is replaced by an RCB with optimized cap. To enhance comparability,
ap* here is defined ‘‘per DRC’’ that is an implicit part of the RCB under consideration. In situation (c), the same
DRC as in (a) is considered, but with given rv = €36.

so that higher caps ceteris paribus only decrease the number of the DAX30 index to be
delivered and the slope of the payoff (net of interest payment) as a function of sT for given
maximum value of €5000 at sT = cap. This reduces the arbitrage-free value of the RCB so
that higher interest payments are needed to hold the fair value of the RCB constant. In the
second situation, we optimize the absolute premium and the redemption value of the DRC
with all other features as described in Section 3.

Result 4. According to the results of Fig. 3, optimal redemption values for DRCs are somewhat
lower than actually observed values. Moreover, the optimization of interest payments is more
important with respect to RCBs than the optimization of rv regarding DRCs. In fact, for
probability weighting functions according to Abdellaoui (2000), there is no inner solution for
the cap of the RCB, as a consequence of the rather ‘‘flat’’ probability weighting. This implies
that possible utility losses due to a higher cap are more than offset by higher interest payments.
In contrast, for steeper probability weighting functions utility gains due to lower caps become
more important than utility losses from lower interest payments so that inner solutions may
exist as Fig. 3d indicates. This result strengthens the importance of the precise identification of
boundedly rational investors’ preferences, which seems to be of somewhat more relevance than
the optimization of redemption values and interest payments in itself, as is indicated by the
absence of an inner solution for RCB optimization in the case of a low competence level and can
also be seen by a comparison of the changes in expected relative gain when switching from Fig.
3a to c (16.08%) and when switching from Fig. 3a to b (+72.52%). Moreover, absolute premia
between €0.5 and €1 seem to be generally advantageous, while lower or higher values might
adversely affect relative expected gains in a significant manner.

The qualitative findings, according to Result 4, seem to be of interest, in particular the

outcome that optimal redemption values and interest payments are of comparatively less
importance than the issue of the level of subjectively felt investors’ competence,8 and the

8
However, once again it should be mentioned that the influence of variations in subjectively felt competence
levels decreases with respect to the desirability of DRCs and increases with respect to the desirability of RCBs
when accompanying changes in stock return expectations are taken into account. See Footnotes 6 and 7.
842 W. Breuer, A. Perst / Journal of Banking & Finance 31 (2007) 827–844

outcome that there is a range of absolute premia which lead to almost the same relative
expected gains. Rather interestingly as well, fully rational investors with a constant relative
risk aversion of 1 or 2 would choose optimal redemption values of €38 or €36 for DRCs
and interest payments of 7.90% or 9.18% for RCBs, respectively, thus deviating – in gen-
eral – significantly from the optimal ones for a boundedly rational investor.
Summarizing, the approach taken in this article indeed leads to several remarkable
qualitative findings, as denoted by the Results 1 and 3. Moreover, it is even possible to
derive quantitative recommendations based on empirical studies and additional distribu-
tional assumptions, as implied by Results 2 and 4. Although there will be no bank that
will trust solely in these optimizing routines, such exemplary computations may help to
provide banks with a better feeling for the opportunities and limits of the market success
of structured products.

5. Conclusion

Our paper was mainly motivated by our intention to analyze discount reverse convert-
ibles and reverse convertible bonds as typical examples of structured products against the
background of the cumulative prospect theory of Tversky and Kahneman (1992) and Tha-
ler’s (1985) hedonic framing rule for mental accounts, with the latter being extended to the
case of uncertain prospects. Moreover, we allowed for the consequences of different indi-
viduals’ competence levels as expressions of varying attitudes towards ambiguity.
We found that DRCs and RCBs are of interest to investors who moderately estimate
the expected return of the underlying stock and who underestimate the corresponding
return volatility. While this result holds true for both fully rational individuals and bound-
edly rational ones, the possible demand for DRCs seems to be significantly overestimated,
if full rationality is used as an approximation of boundedly rational investors. Moreover,
without hedonic framing, the demand for RCBs cannot be understood. Varying compe-
tence levels turn out to be more relevant for the evaluation of DRCs and RCBs than
are the optimization of redemption values, interest payments and absolute premia under
explicit consideration of aspects of bounded rationality. In particular, RCBs become more
interesting for, ceteris paribus, reduced competence. This finding might give rise to some
practical recommendations, such as that of addressing less experienced investors.
Though we have only considered just one specific DRC and a corresponding RCB, our
qualitative findings carry over to other DRCs and RCBs on stock indexes, as long as we
do not alter our distributional and preference-related assumptions, since then, only param-
eters of minor importance – like the time to maturity and the riskless interest rate – could
be changed, while almost all the more interesting parameters have already been the object
of our analyses. Nevertheless, there are several important possibilities of broadening our
examination.
As a first interesting aim for further research, our approach should be extended to the
analysis of more complex portfolio selection problems. This would give rise to the rele-
vance of some kind of systematic risk from the private investor’s point of view. Moreover,
we have only analyzed situations with perfect inter-bank competition, i.e., no positive
profit at all for all banks, as in the scenarios underlying Figs. 1 and 2, and with no com-
petition at all among banks as in the situations examined in Table 1 and Fig. 3. However,
since financial innovations can be replicated quite easily by competitors, possible innova-
tors’ monopoly gains will erode in the long run. As an extreme example, Bertrand compe-
 W. Breuer, A. Perst / Journal of Banking & Finance 31 (2007) 827–844 843

tition among banks without capacity constraints would eventually force absolute margins
to reduce to zero and, thus, imply indeed perfect competition. As known from Kreps and
Scheinkman (1983), Bertrand competition with endogenous capacity constraints leads to
situations which resemble pricing behavior in Cournot oligopolies. Such situations could
also be handled by our approach, because this modification would only reduce accessible
private investors’ wealth W0,tot from the issuer’s point of view without changing substan-
tially the relevance of our analysis. Furthermore, in any case, competition will also induce
banks to steadily create new financial products and to take advantage of temporary
monopoly positions, thus giving a further justification for the analysis corresponding to
Table 1 and Fig. 3.
Finally, we have only considered the most straightforward scenario for the valuation of
DRCs and RCBs, as we did not allow for aspects such as stochastic interest rates and sto-
chastic volatility of stock prices as well as issuers’ credit risk. In the first instance, such
additional risk problems will influence the arbitrage-free valuation of these financial deriv-
atives. While such variations should not affect our qualitative findings, optimal absolute
und relative margins might be influenced. Nevertheless, because of space constraints, such
issues shall be postponed to future research as well.

Acknowledgements

We thank seminar participants at RWTH Aachen University and at the 12th annual
meeting of the German Finance Association in Augsburg. Special thanks are due to
two anonymous referees for many helpful comments. Financial support by the Deutsche
Forschungsgemeinschaft (DFG) is gratefully acknowledged. Any errors are our own.

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