Warrants Pricing Models And Its Application In China Warrants Pricing

Efficient market theory suggests that stock prices follows a process of random walk. Based on this assumption, Fisher Black and Myron Scholes published their option pricing model in Journal of Political Economy in 1973. Then a number of scholars have found in their empirical studies that the distributions of stock return show a high peak and two (asymmetric) heavier tails rather than the normal distribution. They proposed to employ stochastic volatility models to capture these features. Under the stochastic volatility framework, the price and volatility of stocks are changing continuously and gradually. However, the"Black Monday"of 1987 revealed that big jumps exist in the movements of stock price and volatility. To incorporate this feature, Robert C. Merton proposed Mixed Jump-Diffusion Model. For the purpose of attaining a more precise warrant pricing, double Jump-diffusion models have been proposed, as the Single-Jump-Diffusion model is not supported by empirical evidences. Nowadays, as fractional market theory has gradually taken an important position in financial market theories, a new option pricing model based on fractional Brownian motion has been put forward. However, the puzzle emerging from empirical studies is that model biases exist whenever we use model to price options. Therefore, to eliminate this model biases becomes the main objective of option pricing researchers.Warrants are actively traded in China's capital market currently. However, according to empirical evidence, there exists a huge gap between model price and market price. Hence warrant pricing is becoming an important issue demanding further studies. Both in theory and in practice, warrant pricing is a new field and is yet to develop further in China. Nevertheless, relatively few works has been done in this field. Some warrants pricing models and methods have been introduced from abroad. However, there are several layers of studies on warrants pricing which lack of further research. First of all, it is necessary to review warrants pricing models and methods and its development dynamics systematically. Secondly, it is imperative to evaluate the performance of warrants pricing based on these models. Thirdly, it is needed to analyze why the model biases exist. Last but not the least, it is worth to discuss ways to improve the performance of warrants pricing.The objective of this paper is to study and address the issues mentioned above. The paper analyzes the issues theoretically, conducts empirical studies whenever possible and proposes effective solutions to the addressed issues.Since the Black-Scholes model is a significant breakthrough in the history of option pricing. It has always been proved to be one of the most precise option pricing models. Hence, I start my research by applying the Black-Scholes model into the warrant pricing. I assume that assets returns time series follow purely geometric Brownian motion. The paper attempts to find out the best model and method for warrants pricing which minimizes the gap between model price and market price.The major work and findings of the paper are as follows.In the light of the development process of financial market theories, I have systematically studied various models and methods of option pricing. The paper illustrates the context and reasons of their creation, the characteristics and the suitable conditions under which the models and methods can work. The paper also discusses the methods of parameter estimation and the performance evaluation.In order to change the singularity of the construction forms of executive stock options in China, I construct executive stock options in light of path-dependent options. In addition, I discuss a number of products including single barrier option, double-barrier option, Asian style option and Asian-barrier option. The application of these exotic options can improve executive stock options stimulation effects on managers.I have systematically studied equity options pricing in china's warrants market with different option pricing models, especially with Jumps-Diffusion model. By observing it's pricing performance, I have revealed some important problems in China's warrants pricing.According to the characteristics of China's warrants market, I put forward the techniques to eliminate model biases. By establishing regression model for correcting model biases and selecting proper variables, I am able to forecast model biases of option pricing properly so that we can improve the performance of pricing models.I argue that the price of physical goods is determined by the equilibrium of supply and demand. I suggest that warrants price should also be determined by supply and demand for the warrants by investors. So it is desirable that the factors of supply and demand be included as a variable in warrants pricing. I find out that the turnover rate is a good signal that reflects the supply and demand in the market. In addition, it also reflects the degree of market-arbitrage. Adding this factor to the model of correcting pricing errors is a breakthrough of my paper.Furthermore, I propose that we should eliminate the effects of pricing error coming from market conditions in terms of bear or bull market.