This paper investigates Korean retail structured products, uncovering evidence that issuers pro teer by increasing product complexity. Using unique data, for which degree of complexity is measurable by the type or dimension of the underlying asset,
we report monotonically increasing mark-up premia and J-shaped issue amounts in relation to complexity. The result with respect to mark-up premia may be explained in a rational framework considering hedging costs; however, this is not the case with respect to issue amounts, leading us to surmise a hidden issuer incentive. Accordingly, we introduce a simple model, allowing investors with imperfect knowledge, and attempt to reconcile the result with model implications. The model proves that knowledge asymmetry is the key condition for issuers to offer complex products and to enjoy higher excess profit, thus worsening allocative efficiency. Further, we show that the model explains our empirical results well, when knowledge asymmetry is verified as a strictly increasing convex function of complexity.
Key words: Financial Innovation, Complexity, Overpricing, Hedging costs, Mo-nopolistic Competition, Knowledge asymmetry
