Do financial derivatives impact corporate innovation?

Updated on

Innovation drives economic growth, and today is imperative for companies to gain, and maintain, success. But the need to meet quarterly profits and other factors can also hinder executive decision-making to innovate. Can financial derivatives such as options trading activity help executives to overcome short-termism? And, in particular, is there a positive correlation between options trading and a company’s ability to innovate?

Get The Full Series in PDF

Get the entire 10-part series on Charlie Munger in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

Q3 2019 hedge fund letters, conferences and more

Researchers from Colegio Universitario de Estudios Financieros (CUNEF) and IESE Business School in Spain document so, with findings indicating the more option traders follow a publicly-traded company, the more likely its executives are to allocate resources to innovation.

Innovation Influences

In their research “The Bright Side of Financial Derivatives: Options Trading and Firm Innovation,” published in the Journal of Financial Economics, Ivan Blanco of CUNEF and David Wehrheim of IESE examine innovation through the lens of intellectual property with patents and options.

Contrary to beliefs that executives sacrifice long-term gains to meet quarterly profit expectations (which can impair their ability to innovate), researchers suggest that executives learn from market prices (which are more informative when options markets are active).

They find that the more options traders are following a publicly-traded company, the more likely managers are to effectively innovate. Firms with more options trading activity generate more patents and patent citations per each dollar of R&D investment. Findings also support that firms with greater options trading activity pursue more creative, diverse, and risky innovation strategy associated with a more efficient allocation of R&D resources. This, in turn, translates into higher firm value.

Informed Traders

While executives tend to be risk adverse when it comes to their businesses, researchers say, CEOs may feel freer to pursue more creative, diverse, risky innovation with greater options trading activity. With highly-leveraged option traders taking time to understand firm fundaments before making their next trades, executives are simultaneously exposed to more savvy scrutiny as a result. Executives seem to know if they cut R&D to hit short term targets, informed traders will see through this. They are also more likely to pursue more novel levels of innovation.

Wehrheim explains in IESE Insight, "Options are interesting because they provide superior incentives to traders to collect information on firm fundamentals. The traders have an incentive to seek out the annual report, to read it, and, together with many other sources of information, to try to understand how value is created. So, if profitability is low today, maybe it's because the company has invested in some innovation projects and we will see the results in a couple of years."

Does the age of the CEO play a factor in how much they are influenced by options? For instance, are older CEOs potentially less likely to have future concerns or be less involved in their careers, causing them to be less responsive to options? Similarly, are younger CEOs, needing to prove themselves at the beginning of their careers, more likely to be motivated by them?  The effect of options is positive on both, say researchers, but more positive for younger CEOs.

Researchers look deeper into options trading activity

To offer a sense of the magnitude of the effect size of options trading on innovation, researchers estimate an increase of 200 percent in dollar volume of options traded has led to a 31 percent increase in innovation. This is based on the 200 percent growth in total options volume traded on U.S. exchanges from 2000 (676 million contracts) to 2015 (over 3,727 million).

Researchers were motivated by “Options Trading Activity and Firm Valuation” by Richard Roll, Eduardo Schwartz, Avinidhar Subrahmanyam from Anderson School, UCLA, linking options trading to firm value in February 26, 2009, as a starting point for their research. However, theirs is the first research to explore the relationship between options trading and innovation

They used OptionMetrics, as a gold standard for historical options data, as their main independent variable, along with Compustat and the National Bureau of Economic Research Patent Citation database.

Options Trading Activity: Conclusion

While financial derivatives may have a certain perception, and even Warren Buffet has referred to them as “weapons of mass destruction” for their role with subprime mortgages in the financial crisis—they have many positive uses and not just for hedging or in algorithms. The research shows, traders that use them are also concerned about firm fundamentals and managers at firms are also influenced by their use to think of innovation and the longer-term.

The research from Wehrheim and Blanco shows that even if informed traders cannot directly intervene in firm operations they can play a crucial role in motivating innovation. Informed options traders recognize the consequences of cutting R&D activities and invest in options accordingly.

Please see this article for more.

Leave a Comment