Warrants and options retuned to China’s stock market late this year after regulators prohibited derivatives trading for nearly a decade. It marks another big step in the development of the financial markets in China.
Historical Overview
Subscription Rights Certificate
The earliest form of option-like security in China was the Subscription Rights Certificate. The SRC was created in the early 1990s when market demand for Initial Public Offering shares was so huge investors first had to buy the SRCs in order to qualify for participation in a lottery to purchase IPO shares. As a result, a black market for SRCs sprung up in 1992 as retail investors aggressively sought these certificates. The SRC market disappeared shortly after when a bank account-based IPO subscription system was introduced to completely replace the SRC system.
Transferable pre-emptive rights
Compared to SRCs, the transferable pre-emptive right was much closer to a true option instrument in modern capital markets. As early as 1992, a few listed companies issued TPRs in connection with their follow-on stock offering, giving the existing shareholders the right to purchase new shares to maintain their percentage ownership in those companies. Considering existing shareholders may not be willing to purchase--or may be unable to purchase--new shares, the exchanges made such rights transferable and tradable on the exchanges.
This new trading product soon proved to be a magnet for volatility. In many cases the TPRs were traded at a higher price to the underlying stock, a blatant violation of any pricing theory for derivatives, but probably a clear indication of the speculative nature of such TPR trading. As a result, the market regulator moved quickly to ban TPR trading in 1996 following rampant speculation.
Warrants, Options
Warrants and options have now been brought into the market as a financial tool to facilitate the so-called Full-Floatation reform in 2005. The prime goal of the reform is to transform the non-tradable shares into tradable shares, hence the notion of full-floatation. The non-tradable shareholders are required to provide compensation to the publicly tradable shareholders for the floatation right. With listed companies, tradable share holders, and non-tradable share holders balancing their respective interests in the share reform, warrants soon become an attractive alternative to free shares and cash.
The debut of warrants on Bao Steel Co. stock in August 2005 was the first official acknowledgement of equity derivatives in China. The option market is growing explosively but is characterized by extremely volatile trading. For example, the trading turnover rate frequently goes above 100%, and sometimes multiple times that. Many options’ trading price suggests extraordinary high implied volatility. As will be examined below, the T+0 trading system, higher daily price limits than those for shares, and scarcity of tradable options supply all contribute to high volatility.
Characteristics Of China’s Warrant Market
T+0 Trading Mechanism
To facilitate warrant trading, the market regulator permits warrants trading on a T+0 basis, whereby the warrants in China can be bought and sold an unlimited number of times in one day, leading to heavy trading volume and volatility. So far, the A-share stock market implements a T+1 system, thus a newly-bought share could only be sold on the next trading day. The T+0 trading system has led to many trading days where the daily turnover rate of the listed options far exceeded 100%.
Higher Price Limits
The A-share market has a daily 10% limit on up and down price movements; the up/down limits for warrant trading are a lot wider. According to the exchange rules:
Warrant up limit = W (T-1) +(S(T) S(T-1))*125% * Exercise Ratio
Warrant down limit = W (T-1) (S(T-1) S(T))*125% * Exercise Ratio
Where:
W (T-1) is warrant closing price on the previous trading day
S(T) is stock closing price on the day in question
S(T-1) is stock closing price on the previous trading day
Exercise Ratio = how many shares a warrant exercises into (typically 1:1)
For example, if:
On T-1 day, warrant closing price is USD1, and stock closing price is USD10
On T day, stock reaches the up limit, USD11
Then the warrant up limit price is:
W(T) = 1 + (11 10) * 125% = 2.25
That is, for the warrant trading price to reach the up limit, it needs to appreciate (2.25 1)/ 1 = 125% from the previous day’s closing price.
Scarcity of Supply
The key reason for the abnormal trading price is likely due to supply and demand. In behavioral finance studies, financial instruments may be priced much higher than their true value when the following factors exist: lack of supply, insufficient information, and excess liquidity. All these factors exist in China’s warrant market.
Firstly, Bao Steel warrants were the first and only listed warrants in China to start trading. Secondly, warrants were new financial instruments in China so investors were learning to value these complex products. Finally, with A-shares in a multi-year bear market, investors rushed to invest in warrants because they feared being left behind. The dramatic rise of China’s warrant prices provides a perfect case study for behavior finance research.
Conclusion
The launch of warrants and options is a major part of continuing market liberalization in China. It creates a new fast-growing trading market for A-share investors and sets the path for the future introduction of more derivative products. Although this young market is characterized by extremely volatile trading due to the T+0 trading system, higher daily price limits, and scarcity of tradable options, it has the potential to become one of the biggest options markets in the world.
This week’s Learning Curve was written by Winston Ma, head of the corporate products steering committee of the Structured Products Association in New York.