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Rotman Insights Hub | University of Toronto - Rotman School of Management Groundbreaking ideas and research for engaged leaders
Rotman Insights Hub | University of Toronto - Rotman School of Management

What drives risky financial investment decisions

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Ing-Haw Cheng

How do people perceive risk, and how does that influence their financial decisions? With all the risks involved, what motivates investors to trade in the stock market?

These are questions that drive Ing-Haw Cheng’s research and teaching at the Rotman School.

“While financial markets are an avenue for people to build wealth, the market can be volatile and unpredictable," says Cheng, an associate professor in the finance area and the new academic director of the Master of Financial Risk Management program. “Trading products like stocks and derivatives require taking on significant risk.”

Cheng’s research interests in the finance area are broad. He has conducted studies on topics such as the 2008 financial crisis, stock market volatility, commodity futures and speculative trading, and in all of them the common thread is the perception of risk.

“I’m interested in better understanding how financial products behave in the market and helping to demystify the investing landscape for both sophisticated and new investors alike,” he says.

With the introduction of new products to trade, the stock market has dramatically changed in the last decade.

“The financial market, like any market, creates products that people want to trade,” says Cheng. “It’s very interesting how the markets are evolving in a way that facilitates such easy trade of products such as volatility derivatives, bitcoin, cryptocurrencies and non-fungible tokens (NFTs).”

Cheng points to a relatively new market trading financial products that are directly linked to the Chicago Board Options Exchange Volatility Index (VIX) (a measure of how unstable the stock market will be in the future), which effectively creates a market for trading volatility.

“Investors are interested in trading instruments that pay off when volatility is greater than expected, or lose money when volatility is lower than expected. But what may seem like a simple financial product can have many layers of complexity,” he adds.

In one of his recent papers published in the Financial Analysts Journal, Cheng explores an episode in February 2018 dubbed “Volmageddon” when, after nearly a year of low market volatility, the VIX increased more than 100 per cent in a single day. This sudden spike led to sharp losses for short-term volatility investors who had bet that the VIX would remain low. Several high-profile exchange-traded products (ETPs) that track market volatility collapsed, taking with it nearly U.S.$2 billion in investor assets.

“At that time, short volatility ETPs were extremely popular because they had profited from sustained low market volatility in years prior. There was a disproportionately high concentration of these products in the market,” says Cheng.

There were also hedge and leverage rebalancing activities of these ETPs, where the quantity of the products were adjusted to keep up with demand.

“This led to a feedback loop that pushed prices higher and higher, quickly amplifying each product’s losses,” he adds. “The rapid growth of ETPs in the financial market is one of the key financial innovations in the last decade, but there are risks associated with hedge and leverage rebalancing when markets are highly concentrated and volatile.”

What’s the lesson for investors?

“Investors should take care to fully understand a new financial product before they trade it,” Cheng says.

Ing-Haw Cheng is an associate professor of finance at Rotman. He researches how beliefs and incentives affect capital markets and the economy.