China’s Option Product—Covered Warrants’ Delta-Hedging Strategy Based On Different Volatility Estimation Methods

With the accelerating of financial reform financial innovation in China’capital market, varieties of financial instruments that have the option properties have been launched, including covered warrants, equity warrants, convertible bonds and financial products issued by commercial banks and foreign exchange options products. Covered warrants are among the most tortuous on the road of development but also the most significant study on behalf of the class of option derivatives, which first appeared in 2005 in China. Its appearance has been strongly concerned and its trading volume has even exceeded that in Hong Kong on China’s securities market holding, but was forced to shut down in the end due to excessive speculation existed in the market. With the rapid development of options derivatives markets abroad, China has begun to focus on options product, and accelerate the pace on the preparatory work of option trading since last year. The four major futures options trading simulation has full debut. As a reference for the best experience, the research on covered warrants is undoubtedly essential. Also based on this, the paper research two mainly risks the covered warrants issuers faced: pricing risk and hedging risk.Firstly, the volatility is the only one of the parameters controversial in the classic Black-Scholes pricing formula and its modified model later. The practitioners overseas mostly use quantitative models or VIX volatility index to predict the volatility value. However, the VIX index information in China can not be obtained in the case of the lack of options market. This paper selects six covered warrants issued during three years from the history of China warrants market to examine the applicability of pricing power in China warrants market of historical volatility and a quantitative volatility from an empirical perspective. The results show that GARCH models to quantify the volatility of the warrants market is most excellent predictive model.Secondly, in the face of dynamic delta-hedging risk after the warrants’ issuance, this paper selects GARCH model as the described method of the initial volatility, take three classical models based on adjusted volatility—Hayne E. Leland model, Boyle-Vorst model and Whally-Wilmott hedging strategy to build dynamic delta-hedging strategies in China warrants market, and then get hedging gains and losses derived these three interrupted transactions individually. The research shows that Whally-Wilmott hedging strategy is significantly better than the other two models.Then, this paper explores the reasons why Leland model and B-V model have the poor performance in China warrants market theoretically and empirically and propose a new dynamic hedging strategy--delta-hedging strategy based on linear adjustment presets volatility up to the diagnosis. The new strategy exhibit slightly higher earnings expectations, but also a relatively stable earning trend compared with Leland model and B-V model which is suitable for hedging strategies of warrants issuers and sound-based investors in the initial operation of the market.Finally, combined with the volatility forecasting methods and dynamic hedging strategies explored above, some suggestions are given to the upcoming options market as well as option products’ issuers.