Mispricing of Chinese warrants

•The Chinese market overpriced put warrants and underpriced call warrants.•Financial institutions made a profit of $3 billion by exploiting the mispricing.•Investors were paying a premium to trade warrants for speculation/trading purposes.•Concerns over the potential burst of stock bubble also contributed to the mispricing.

From August 2005 to December 2008, a total of 54 warrants were issued in China. Trading in China's warrant market was extremely active — on a daily basis, turnover often exceeded one. Using three standard pricing models, we document that put warrant market prices averaged 1.2 yuan more than model-generated prices, while call warrant prices averaged 1.9 yuan less. Financial institutions that were authorized to create new warrants exploited these pricing anomalies and generated 20 billion yuan (over $3 billion) in creating overpriced put warrants. We identify two important factors that explain the mispricing. First, we show that the P/E ratios of underlying stocks are related to the overpricing of put warrants and the underpricing of call warrants. This suggests that investors took the potential burst of a stock market bubble into account and thus imposed an implicit discount on the value of stocks when pricing warrants. Second, investors were paying a premium on warrants to fulfill their speculation/trading purposes. Investors also switched from stock trading to warrant trading after an exogenous increase in a stock transaction tax.