The link between intraday signals and call warrant mispricing

Abstract

This study proposes a linkage between intraday variables (signal amounts and signal duration) and the mispricing of Taiwan call warrant prices, based on the lower boundary condition of Merton [1973. Theory of rational option pricing. Bell Journal of Economics and Management Science, 4(1), 141–183] as modified by Galai [1978. Empirical tests of boundary conditions for CBOE options. Journal of Financial Economics, 9(2), 321–346]. Trading mispriced call warrants associated with a riskless hedging strategy over the period January 2004–December 2005 on average produces abnormal profits after taking into account transaction costs, as indicative of an inefficient market.

Keywords:

• call warrants
• lower boundary conditions
• market efficiency
• signal amount
• signal duration

Acknowledgements

The work of Yeh was supported by a grant from the National Science Council in Taiwan (grant number: NSC 97-2752-H-005-001-PAE).

Notes

After accounting for transaction costs, arbitrage is deemed to ‘exist’ if non-negative trading profits can be earned and the duration of the trading strategy is long enough for a trader to take advantage of the mispricing. For example, in the US stock market, information is embedded in prices in <5 s. Thus, the US stock market is assumed to be efficient since the duration of inefficiency is too short for most traders to take large positions.

Option market makers and warrant issuers in Taiwan can short sell stocks arbitrarily for the purposes of arbitrage and hedging, whereas individual investors can short sell stocks when the price is greater than the closing price on the previous trading day.

347/1611 = 21.54% (Table 4).

217/434 = 50% (Table 4).

648/1611 = 40.22% (Table 6).

304/434 = 70.05% (Table 6).

Compared with the TSE stocks that had trading volumes of 987.5 billion in 2004 and 663.5 billion in 2005, the call warrants had trading volume only 10.25% and 17.76% of the equity volume.