An Empirical Research On The Deviation Between Market Price And Theoretical Value In Chinese Warrant Market

Warrants, as the basic financial derivative instruments, have experienced a history near one hundred years and keep flourish development in Europe and Asia, especially in Germany and Hong Kong. Warrants are broadly welcomed by many investors because they are characterized of high leverage. In the mature markets, warrants are playing an important role in price discovery, hedge and risk management. Since introduction of warrants again during the Split Share Structure Reform starting from the year 2005, China's warrant market has developed rapidly and continues to expand, which's trade volume ever exceeded that of Hong Kong market and became the largest market around the world in 2006.However, the huge volume was created by a few dozens of warrants, so what happened behind the phenomenon? In fact, Chinese Mainland warrant market is flooded with investors'irrational speculation, where warrant price rockets or slumps frequently, which is unusual even in the worldwide market. That situation occurred in the early 1990s and finally caused the market to be close down. Since then, more and more literatures began to study on warrant market, but most of them only focused on the efficiency of pricing model and lacked of analysis for post-reform market due to short of trading data. Therefore, it makes sense to investigate into warrant market, either for academy or in guiding practice.This paper examines the fourteen equity warrants that attached to separately traded convertible bonds in Shanghai and Shenzhen warrant market, deals with the deviation between market price and theoretical value and throws light on market development path. First, stock volatility is estimated by GARCH family models, which measure the fat tail of the distribution of stock yield, and is used to monte carlo simulation pricing model by which the theoretical value is found out. Next, while comparing market price to theoretical value, the factors influencing price deviation are studied via turnover rate, price premium rate, ratio of stock price to warrant price and time remained to expiration. Then the reasons are further analyzed from the perspective of both institution and investors, combining with practice in Hong Kong markets. Empirical research show that warrant prices are much higher than their theoretical value, that they are generally overestimated by 1000% at average, and that they do not return to its theoretical value when expiration date is approaching. This paper believes that the reasons for price deviation mainly due to two aspects. On the one hand, the market institution is imperfect, short sale mechanism and market-maker are absent, supervision lags behind, policies change casually and warrants supply is inadequate. On the other hand, the investors'incorrect understanding of the warrant and irrational behavior increase the seriousness of the problem.Chinese mainland warrant market should learn from the market failure in the 1990s, absorb success experience from Hong Kong markets and choose proper development path with supervisal mode and measures compatible to market risk endurance according to emerging and transitional market characteristics, so as to establish a sound and stable warrant market, and moreover, build a solid foundation for further development of financial derivative market.