Options and structured warrants on the Hong Kong exchange : pricing processes and credit risk

Abstract

Traditionally, options have been the preferred derivative in Western markets, whereas in Hong Kong and much of Asia, warrants are preferred over options as hedging vehicles. Empirical studies have shown that the pricing of warrants differs from that of options. These studies examined the value of warrants without determining the underlying process implied by actual warrant prices. Moreover, most research focuses on developed markets like the US or Japan, or on inferring the price of warrants from options prices. This research set out to examine the asset pricing processes underlying exchange-listed options and structured warrants on the Hang Seng Index (HSI). It also aims to examine the effect of warrant-issuers’ credit ratings on pricing differences between HSI Options (HSIO) and HSI Warrants (HSIW). The study addresses several research questions: “Are both continuous and jump components present in the asset pricing processes of HSIO and HSIW?” and “If so, do these components interact over time?”; “Are there differences between the asset pricing processes of HSIO and HSIW?”; “Does the price of HSIW depend on the warrant-issuer?” and “Do issuers’ credit ratings have any effect on the different pricing between HSIO and HSIW?” Hypotheses were developed to investigate these questions. To address the research questions and hypotheses, this study adopts: (a) Carr and Wu’s (2003b) method of identifying the presence of jump and continuous components in the asset pricing; and (b) Chan and Pinder’s (2000) applied regression analysis test. This test was used to find evidence of different pricing between options and warrants in the Australian market. This research uses data in the Hong Kong market with a sample period from 2009 to 2013. Carr and Wu’s (2003b) method, was used to create term decay plots for HSIO and HSIW to determine the components in the asset pricing processes of these securities. Then, Chan and Pinder’s (2000) regression analysis method was used to investigate differences in pricing between HSIO and HSIW, and the effect of warrant-issuers’ credit risk on HSIW pricing. To the best of the researcher’s knowledge, this research is the first to determine the process underlying HSIO and HSIW prices by examining the term decay plots of these securities in the Hong Kong market. It contributes to the literature by examining not only a different market but also a different financial product. It therefore extends prior research by enabling the comparison of findings in two different markets and products. Evidence was found (a) of a continuous component and a weak jump component in the asset pricing process of HSIO, broadly consistent with Carr and Wu’s (2003b) findings for S&P 500 put options on the NYSE,(b) of a purely jump component in the asset pricing process for HSIW,(c) that characteristics of warrant issuers are associated with relative pricing differences between HSIO and HSIW, and (d) that one of these characteristics is the credit risk of the warrant-issuer. Future research could seek to establish a means of investigating further the pricing processes underlying the HSIW. Ideally the methodology would incorporate the role of credit risk, as this study has shown it is a significant factor in HSIW price behaviour. Given the scarcity of literature on structured warrants, this research can help warrant issuers adopt better hedging techniques to reduce risk when issuing warrants. This study potentially assists investors to improve their use of warrants as hedging, arbitraging, investing and speculative vehicles. It is hoped that the findings will expand researchers’ understanding of the components in the asset pricing process of options and warrants. It is also hoped that the thesis will provide insight into the different pricing between options and warrants due to different components in the underlying processes.

Date of Award	2016
Original language	English
Supervisor	Ian Maclean (Supervisor), Monir Mir (Supervisor), Siqiwen Li (Supervisor) & Monica Kennedy (Supervisor)