Are Chinese warrants derivatives? Evidence from connections to their underlying stocks

Abstract

In this paper, we empirically investigate warrant price behaviour in the Chinese market—the largest warrant market in the world in terms of trading volume since 2006. By examining warrant return properties, volatility behaviour and pricing errors, we document a stylized fact that call warrants have a considerable linkage with their underlying but put warrants have almost none. The combination of the arbitrage pricing theory and the resale-option bubble theory (proposed by Scheinkman and Xiong in 2003) is adopted to explain this stylized fact. Specifically, the arbitrage pricing framework tells that it is possible for puts (calls) to be overpriced (underpriced) due to short-sales prohibition in the Chinese stock market, while the resale-option bubble theory proves that puts do have bubbles but calls do not. The bubble dilutes the linkage between put prices and their underlying stock prices. Our findings have implications for Chinese investors as well as the derivatives regulator.

Keywords:

• Warrants
• Chinese market
• Short-sales prohibition
• Arbitrage pricing theory
• Resale-option bubble theory

JEL classification:

• G12

Acknowledgements

KT acknowledges financial support from the National Natural Science Foundation of China (Grant No. 71171194). CW acknowledges financial support from the Fundamental Research Funds for the Central Universities, and the Research Funds of Renmin University of China (Grant No. 12XNL001). The authors thank Ting Ting Yu and Xizhi He for excellent research assistance, and two anonymous referees for their comments and suggestions which have greatly improved this paper.

Notes

¹The ‘T+1’ rule requires investors to hold their stocks for at least one day before selling; the ‘T+0’ rule allows investors to sell warrants purchased on the same day.

²Note that neither of the two theories can itself explain this stylized fact. For example, resale-option bubble theory cannot explain why it is puts but not calls that generate bubbles. On the other hand, arbitrage pricing theory cannot explain why puts have much weaker linkage with underlying stocks than calls.

³Tradable A-shares are ordinary shares available exclusively to Chinese citizens and institutions. B-shares are denominated in US or HK dollars and were designated for overseas investors prior to opening the market to domestic investors in February 2001.

⁴Bai et al. (2004) provide some good discussion of these issues.

⁵For a discussion of this price interval, please refer to Karatzas and Kou (1996).

⁶We believe that the percentage error is more ‘robust’ in testing the relationship between warrants and their underlying. When judging whether theoretical models fit well with market prices, people tend to use the percentage pricing error (or log price difference); for example, Dempster and Tang (2010) focus on the log price difference when studying the specification of the pricing errors of various term-structure pricing models.

⁷The fact that pricing errors decrease as warrants approach their maturities is a necessary condition but not a sufficient condition that warrants belong to the set of derivatives. For example, an overvalued bond will converge to its face value when it approaches maturity. We thank the referee for pointing this out.

⁸Since the theoretical put prices are very small, they are neglected in Xiong and Yu (2011) .

⁹For a robustness check, in the calculation of the warrant volatility we also use the average return of the past ten days as the mean return. The regression results are in general not altered. We omit the results here out of concern for brevity, and the complete details can be provided on request.

¹⁰Note that b has to be positive if it has features of option-type derivatives, thus two significantly negative coefficients in table 2 do not count.