Are Derivative Warrants Overpriced?

Abstract

This study investigates the pricing efficiency of Hang Seng Index (HSI) derivative warrants in Hong Kong. Different from similar research, the study examines the pricing efficiency of index warrants by comparing their implied volatilities (IV) with realized volatility (RV). Although prior studies find that warrants are more expensive than the corresponding options, they are not necessarily overpriced in the conventional sense—that is, relative to the RV. This approach allows the study to test the pricing efficiency of warrants via a test of their information content. Moreover, unlike studies that focus on data at market close, the study uses a large sample of highly synchronous intraday, firm, bid–ask quote data to avoid possible distortions arising from intraday variations in liquidity and pricing in the instruments. The data also helps eliminate the potential nonsynchronous price problem that may affect the test results. Consistent with the results from previous studies, we find that warrants are often more expensive than options. This result is attributed to the inability of non‐issuers to sell short, and the high participation rate of unsophisticated investors in the warrants market. However, regression analysis shows that IVs from ATM and OTM warrants provide unbiased volatility forecasts, and that IVs from ATM options do not subsume the information content of ATM warrants. ATM warrant prices are in line with the RV and are efficiently priced. Simulation results show that writing warrants is more profitable than writing options, and that the overpricing is directly related to the volatility premium.

Why are the prices of European‐style derivatives greater than the prices of American‐style derivatives?

“…In addition, derivative warrants show better liquidity than matched options. The results confirm the overpricing behavior between derivative warrants and options written on individual stocks in Hong Kong, which is consistent with the findings for derivatives written on the HSI (Fung & Zeng, 2012; Li & Zhang, 2011). Next, we use linear panel regression to examine whether liquidity differences and other relevant factors can explain this overpricing behavior.…”

“…Using daily quote data on derivative warrants and options written on the HSI for the 2002–2007 period, Li and Zhang (2011) find that the liquidity premiums of derivative warrants over options reflect the better liquidity of warrants, while clientele effects explain how warrants and options can coexist in the markets. Fung and Zeng (2012) extend the work of Li and Zhang (2011) to show that short‐selling restrictions and a high proportion of unsophisticated investors lead to overpriced derivative warrants with overestimated implied volatility. Li and Zhang (2019) show that in addition to liquidity, counterparty credit risk and investor gambling preferences can explain the price differences between derivative warrants and options.…”

“…Price differences between derivative warrants and options are little explored in the literature. The phenomenon of derivative warrants being more expensive than otherwise identical options is common in regions where these two markets coexist, such as in Hong Kong (Duan & Yan, 1999; Fung & Zeng, 2012; Li & Zhang, 2011, 2019), the Netherlands (Horst & Veld, 2006), and Australia (Chan & Pinder, 2000). Using daily quote data on derivative warrants and options written on the HSI for the 2002–2007 period, Li and Zhang (2011) find that the liquidity premiums of derivative warrants over options reflect the better liquidity of warrants, while clientele effects explain how warrants and options can coexist in the markets.…”

“…The phenomenon of more expensive derivative warrants does not necessarily mean that the warrants are overvalued (Fung & Zeng, 2012); thus, we test their pricing efficiency and explain what causes the difference in pricing efficiency between the derivative warrants and options markets. Following Chordia et al (2008), we use variance ratios and return predictability from order flows to examine the efficiency of each market.…”

Issuers’ credit risk and pricing of warrants in the recent financial crisis

“…These profit and cost components explain why various SFPs are overpriced as a wide range of literature has documented (Bartram et al, 2008;Muck, 2006;Loudon and Nguyen, 2006;Baule, 2011;Fung and Zeng, 2012;Baule and Blonski, 2014). The literature also documents that a higher product complexity, in terms of multiple barriers or other characteristics influencing the payoff profile, comes along with higher overpricing (Entrop et al, 2014;Baule and Tallau, 2011).…”