Abstract:

In Hong Kong, pricing differences between stock options and derivative warrants of same underlying exists.Theoretically, they should be the same. Galai and Schneller (1978) demonstrated that the identical warrants and call options should have the same price. The paper showed a warrant’s rate of return to be fully correlated with the rate of return of option with similar terms. While the systematic risk of both derivatives will be the same, the price of the warrant will be a fraction of the price of the call option and this fraction or conversion ratio is exactly the number of shares represented by the warrants to the number of “original “shares.

In reality, pricing differences do exist. Past researches showed the price differences between the options and warrants in the American, European and Asian derivative markets. Most of the papers described such price difference belong to the existence of market imperfection. Nevertheless, there are two different views of the existence of price differences. Veld and Verboven (1995), Horst and Veld (2002) and Hirshleifer(2001) clarified that warrants issuers charge the higher price on the warrant buyers because of the private investor preference and marketing strategies On other hand, Green and Figlewski (1999) illustrated the issuers gain the higher return by writing the overvalued warrant to compensate their higher degree in model risk. Chung, Lee and Wu (2002) found that the issuers expose the larger model risk in writing warrants in the emerging derivative market. Chan and Pinder (2000) clarified that warrants are charged higher price to investors since they have better liquidity than options.

The rest of the paper is structured as follow: Section 2 reviews the evidence of pricing differences from past research. Section 3 reviews the reasons for the existence of pricing difference. Section 4 reviews researches accept the overvaluation of warrants. Section 5 is the conclusion.

Keywords:

stock options, derivative warrants, asset pricing.