The Chinese Warrant Bubble: A Fundamental Analysis

Abstract

Based on a rational option pricing framework that incorporates short-selling and margin-trading constraints in the stock market, we present evidence that Chinese warrant prices, which are regarded as bubbles in the previous literature, can be explained by a new option pricing model. Based on the new model, we develop a warrant-price deviation measure to quantify unobserved demand for short-selling or margin trading due to market constraints. We empirically show that warrant-price deviation is driven mainly by underlying stock valuation. We conclude that the Chinese warrant market is better characterized by derivatives rather than a pure bubble detached from underlying assets.

Keywords: Warrant bubble, short-selling and margin constraints, put-call parity

JEL Classification: G12