3.9.2. Derivatives

Hon (2013a) attempted to identify the ways that the Hong Kong companies in the Hang Seng Index Constituent Stocks manage their financial risk with derivatives. By analyzing the companies' annual reports and financial reviews, it was found that 82.6% of these companies used derivatives in 2010. Specifically, 58.7% of them used swaps to hedge interest rate risk, and 54.3% of them used

forward contracts to hedge foreign-exchange risk. The results are largely consistent with the prediction that companies use derivatives to manage their financial risk.

By investing in stocks, bonds, and other financial assets, people have been able to build up a bu ffer in case of being dismissed. Firms have tilted their compensation packages to managemen<sup>t</sup> away from fixed salaries toward participation and result-based compensations, such as stock options. With such options, managemen<sup>t</sup> has an incentive to do everything possible to boost share prices. They have an incentive to maintain an appearance of corporate success and a corporation working its way toward an impressive future with increasing profits. It seems as a strategy to boost the stock value and to refine the company's objectives and announcing that it was a part of the e-business society.

Heath et al. (1999) investigated stock-option-exercise decisions by over 50,000 employees at seven corporations. Controlling for economic factors, psychological factors influence exercise. Consistent with psychological models of beliefs, employee exercise in response to stock price trends—exercise is positively related to stock returns during the preceding month and negatively related to returns over longer horizons. Consistent with psychological models of values that include reference points, employee exercise activity roughly doubles when the stock price exceeds the maximum price attained during the previous year. Options have no purchase price to serve as a reference point.

Employees do not purchase options; they receive them at a strike price that is equal to the stock price on the date of the grant. Because employees can only exercise their options when the stock price exceeds the strike price, reference points, if they exist, will be dynamically determined by stock price movement after the grant.

CEO compensation has grown dramatically. Average CEO compensation as a multiple of average worker compensation rose from 45 in 1980, to 96 in 1990, and to an astounding 458 in 2000. A large portion of this compensation comes in the form of stock options. Economists fear that managers will behave more conservatively than is in the best interests of shareholders because managers' careers are tied to the firm. Executive stock options mitigate this problem by rewarding managers when the firm's share price goes up but not punishing them when it goes down. Such convex compensation contracts encourage managers to take risks.

Gervais et al. (2011) argued that executives are likely to be overconfident and optimistic, and thus biased, when assessing projects, and that many shareholders are under-diversified and do care about specific risk. A manager may further manipulate investor expectations by managing earnings through discretionary accounting choices. Furthermore, research indicates that earnings manipulations can affect prices.

Derivatives are a new segmen<sup>t</sup> of secondary market operations in India. Ganesan et al. (2004) found that a buoyant and supporting cash market is a must for a robust derivative market. Hon's (2015a) found that the majority of respondents who invested in their derivative investments during January 2013 to January 2014 in Hong Kong were relatively younger. More than 58.1% of the respondents had tertiary education for their derivatives investments. Males preferred to invest in warrants more than females did, while females preferred to invest in stock options more than males did.

Hon (2015c), based on the survey results, derived the ascending order of importance of reference group, return performance, and personal background (reference group is the least important and personal background is the most important) in the Hong Kong derivatives markets. The results of Hon's paper (Hon 2013c) indicate that small investors mostly tend to trade Callable Bull/Bear Contacts (35% of total) and warrants (23% of total). Hon (2012) identified five factors that capture the behavior of small investors in derivatives markets in Hong Kong. The factors are personal background, reference group, return performance, risk tolerance, and cognitive style.
