Resale Option Theory And Put Warrants Bubbles In China

During2005-2008, there were18put warrants listed for trading in domestic exchanges. The dramatic bull market of2005-2007madethe intrinsic values of these warrants close to zero, but their prices were much higher than zero, which means obvious bubble in Chinese warrant market.Based on Xiong and Yu (2011)’s research,"The Chinese WarrantBubble", this paper re-calculates the theoretical prices of warrants and improves their panel regression method, to verify the resultsof the previous research and found extremely active transactions and very large volatilities of these put warrants during their zero-fundamental periods, which can be well explained by the resale option theory.This paper conducts further study of Xiong and Yu (2011), and extended their research in the following aspects:firstly it studies the relationship between warrants creation and bubble size, and finds out that increasing bubble had made creation more attractive to security firms, while new warrants creation in return restrained bubble size. Secondly, this paper adds the influence of index to bubble models, and finds out that when index was above4000points, some investors held put warrants to hedge jump-to-ruin risk of underlying stocks, thus making resale option theory no longer applicable.Finally, this paper explores two possible reasons for the lasting warrant bubble: on one side, due to short-selling constrains, rational investors like institutions, their participation in the warrant market is very small, without enough power to suppress the bubble; on the other hand, new irrational or inexperienced investors continuously enter this market, making the bubble grow bigger.Although warrant has withdrawn from the security market in China since August2011, the development of our derivative market cannot be stopped. Only in an improved market with short-selling methods and more rational investors, can the security bubbles be avoided. This is especially important for a better understanding of the derivative market and a more stable financial environment.