Sunday, March 24, 2013

Overpriced Chinese Warrants

An interesting article in the Feb 2013 Journal of Financial Markets notes the persistent overpricing of Chinese Warrants. Chang, Luo, Shi, and Zhang, all Chinese academics, examined looked at 47 warrants traded on the Shanghai or Shenzhen exchanges, from 2005-2008.  The implied volatilities are about 3 times the historical in their dataset; 150% average implied vs. a 50% average historical volatility.

Above is an anecdote of how the market price tracks a Black-Scholes price given historical volatility as opposed to the market price (blue is market price, magenta is the model price). It's basically impossible to tell a rational story for the market price.

These warrants were all basically options, as they allow continuous creation which allows issuers or other approved institutions to add to supply at at time.  As warrants cash settle every day, they make for a popular investment, often with volume far exceeding the underlying equity.

It makes one wonder, if there markets are this unhinged from reality, how uncertain China is as a long term investment. I mean, they are doing a lot of things right, but their institutions aren't exactly promoting rational price discovery. It also highlights that preventing shorting is one of the stupider regulations in the world, because without shorts, stupid prices persist a lot longer.

1 comment:

Anonymous said...

Chinese warrants are useless indicators of anything, they can be so ridiculously mispriced because the financial system there is not properly functioning that they don't tell you anything except "ordinary investors don't understand warrants."

Are there implications for the general economy because of this? I doubt it. People are irrational all the time but these are still fairly small amounts of money.

Here's an AER from 2011 on the same topic