Lessons from the Chinese Warrants Bubble

XIONG, Wei | YU, Jialin

History is scattered with spectacular asset price bubbles, from the Dutch tulip bubble of the 1600s to the Internet bubble of the late 1990s. These bubbles have been studied in minute detail to understand how and why their price came to exceed their fundamental asset value, but the studies have been disadvantaged by incomplete information and hindsight. What if there were a real-life situation with controlled conditions that could enable observers to track the formation of a bubble?

Such a situation existed in China in 2005-08 when a huge warrants bubble formed – and with it, data that showed in great detail how the bubble formed and how actors reacted to it.

The warrants had been issued in 2005 and enabled investors to hedge or speculate on the underlying stocks. The values of these stocks had conditions that might have been considered a counterbalance to a bubble – they were publicly observable and the warrants had predetermined finite maturities. Yet they sparked a frenzy and, in the case of put warrants, ended up being so deep out of the money that they were certain to be worthless.

As Wei Xiong and Jialin Yu, who have studied the bubble, pointed out: “They generated a spectacular bubble as dramatic as, if not more so than, any other bubble episode. For each warrant, billions of yuan was traded with an average daily turnover rate over 300 per cent, and at substantially inflated prices.”

This was despite public announcements by the Shenzhen and Shanghai stock exchange cautioning investors about the disparities between the stock price and warrant strike price. So what drove investors to trade so much and pay inflated prices? One of the more extreme examples, the ZhaoHang put warrant, had a trading volume of roughly US$7 billion in one day even though it was virtually worthless from exercisinig.

Optimism seemed to have played a part, according to the authors. Optimistic investors may have believed they would be able to resell the asset in future to an even more optimistic investor, and this drove prices higher. This belief was underpinned by a ban on short-selling financial securities in China and different ideas among investors about warrant fundamentals.

“Anticipating other investors’ beliefs to fluctuate over time, a warrant buyer may be willing to pay an inflated price because he has the option to resell the warrant to someone else in the future for a speculative profit.

“The more investors disagree about future price movement, the more intensively they trade with each other and, at the same time, the more willing they are to pay for the resale option. When the asset return is more volatile, investors also tend to disagree more, which makes the bubble larger.”

The gradual decline of warrant prices before and during the last trading day supported this theory because it implied a waning of opportunities to resell for speculative profit.

The authors also found evidence of a “feedback loop” may also have been driving prices higher in short intervals of several minutes, and that smart investors may have been riding the bubble.

Alternatively, little evidence was found from the 18 put warrants studied to support other possible explanations for the bubble – such as investors hedging risk in the underlying stock, the development of a “rational” bubble, institutional investors’ agency problems and gambling behavior by investors.

“Identifying bubbles in real time is challenging. But the bubble properties we identify, in particular that bubbles tend to be accompanied by trading frenzy and large price volatility, can help sharpen real-time bubble detection in other, more complex asset markets,” they said.

YU, Jialin

Academic Director, HKUST-NYU Stern MSc in Global Finance, MSc in Investment Management (Full Time), Associate Professor