A Comprehensive Study of the Chinese Warrants Bubble

Abstract

We conduct the most comprehensive study to date of the Chinese warrants market in terms of the length of the sample period and the variety of the warrants investigated. During our sample period from August 2005 to September 2009, the underlying Chinese stock market peaked in October 2007, and then crashed dramatically. Starting by the end of October 2008, the market recovered steadily. We examine the pricing of put warrants, as well as covered call warrants and (uncovered) equity call warrants during such market swings. Our analysis indicates that Chinese warrants exhibited large pricing bubbles as their market prices significantly deviated from those implied by option pricing models. We show empirically that the bubble size is positively related to turnover, daily price change, and negatively related to the total number of warrants outstanding. These results are consistent with the prediction of the Greater Fool Theory: an investor buys securities without regard to their fundamental value, but with the hope of quickly selling them off at a higher price to another investor who might also be hoping to flip them quickly. Moreover, we find evidence that the stock price declines associated with the conversion of previously state-owned non-tradable shares into tradable ones dampened the bubble behavior for those companies’ covered call warrants, relative to warrants on companies that did not participate in share conversions.

Keywords: Emerging market, warrants, bubbles, short sale constraint, ownership reform

JEL Classification: G12, F30