Are Investors Irrational? - Study on China Warrant Market

Abstract

This paper studies Chinese warrant price deviation. By observing “asymmetric price error” phenomena, we propose that the rational hedging and speculation motivation is one important cause for warrant price deviations. Investors do not speculate irrationally under the resale motivation all the time, neither do they ignore warrants’ hedging function. Instead, investors would trade for hedging and speculation purpose and drive the warrant prices when the underlying assets are significantly undervalued or overvalued. The paper applies a model-free measure for warrant price deviation and verifies the proposal by studying five couples of warrants from 2006 to the beginning of 2008. It has been found that the rational hedging and speculation motivation dominates other trading motivation in the market.

Keywords: Warrant bubble, hedging motivation, rational speculation, put-call parity

JEL Classification: G1, G32