This paper first studies the Chinese warrant market that has been developing since August 2005. Empirical evidence shows that the market prices of warrants are much higher systematically than the Black-Scholes prices with historical volatility. The prices of a warrant and its underlying asset do not support the monotonicity, perfect correlation and option redundancy properties. The cumulated delta-hedged gains for almost all expired warrants are negative. The negative gains are mainly driven by the volatility risk, and the trading values of the warrants for puts and the market risk for calls. The investors are trading some other risks in addition to the underlying risk.

China launched her warrant market in August 2005 in the split share structure reform of listed companies. As up to now, equity trading on margin and short-sale of any form are still prohibited in China. This warrant market enables investors to trade on information that otherwise might be prohibitively expensive to trade on. The Chinese warrant market created top trading volume and turnover with only a handful of different warrants traded. This paper first studies the Chinese warrant market. Empirical evidence shows that the market prices of warrants are much higher systematically than the Black-Scholes prices with historical volatility. Moreover, the paper documents ample evidence that the one-dimensional diffusion model does not apply well in the Chinese warrant market. The prices of a warrant and its underlying asset do not support the monotonicity, perfect correlation and option redundancy properties. The paper also studies the cumulated gains of a delta-hedged warrant portfolio. In the Chinese warrant market, the cumulated delta-hedged gains for almost all expired warrants are negative. The negative gains are mainly driven by the volatility risk, and the trading values of the warrants for puts and the market risk for calls. The investors are trading some other risks in addition to the underlying risk.

In 2005-08, over a dozen put warrants traded in China went so deep out of the money that they were certain to expire worthless. Nonetheless, these warrants attracted a speculative frenzy: for each warrant, billions of Yuan traded with an average daily turnover rate close to 300%, and at substantially inflated prices. The publicly observable underlying stock prices make the zero warrant fundamentals common knowledge to all market participants. This warrants bubble thus presents a unique opportunity to study bubble mechanisms, so far only available in laboratory environments. We find evidence supporting the resale option theory of bubbles: investors overpay for a warrant hoping to resell it at an even higher price to a greater fool.

This paper explores whether the pricing of the option-type derivative is affected by some of fundamental characteristics, such as size and liquidity of the derivative itself and the underlying asset, which are not involved in the standard pricing theory. Considering the unique status of warrants in China due to the relatively more flexible trading mechanism, I empirically examine the pricing of Chinese covered warrants to develop this study. Empirical results show that market prices of Chinese warrants are significantly higher than theoretical prices predicted by traditional pricing models such as Black-Scholes, Jump-Diffusion, and CEV model. For call warrants, about 25 percent of the market price can not be explained by pricing models, and this figure rises to over 60 percent for put warrants. Further regression tests show that both size and liquidity of warrants and underlying stocks significantly affect warrant pricing errors. The way in which the size and liquidity affect the pricing error depends on the type of warrants. In addition, it is evident that movements of put warrant prices in China do not follow movements of stock prices. To explain the above pricing puzzles,the concept of functional asset pricing is proposed. According to this concept, these pricing puzzles just reflect the existence of functional value of financial instruments that has long been neglected by traditional pricing models. In fact, Due to the high level of liquidity and popularity, the Chinese warrant may well function as a good tool for obtaining short-term profits. The pricing of Chinese warrants by the market may correctly re°ect the value of this function, and thus is rational in essence.