Academic journal article Journal of Economics and Finance

An Analysis of Australian Exchange Traded Options and Warrants

Academic journal article Journal of Economics and Finance

An Analysis of Australian Exchange Traded Options and Warrants

Article excerpt

Abstract

This study focuses on the price discovery process in Australian option and warrant markets. Characterizing these two markets in terms of their cost structures and institutional features, we formally test competing price discovery hypotheses. The general findings indicate that the warrants market is the dominant market suggesting that their lower trading cost outweigh their less attractive institutional features. Additionally, we find that idiosyncratic differences among firms may result in a clientele effect thus providing justification for the coexistence of these seemingly redundant markets.

Keywords Options and Warrants * Price Discovery * Error Correction Models

JEL Classification G 14 * G15

1 Introduction

In 1991 the Australian Stock Exchange (ASX) introduced exchanged traded equity warrant contracts. In direct competition with existing exchange traded equity options,1 these warrant contracts offer the holder the right, but not the obligation, to buy or sell a given quantity of an asset at or before a pre-specified date for a given price. Additionally, as in the case of equity options, the exercise of warrants results in either a transfer of ownership in existing equity in exchange for the exercise price, or a cash settlement depending on contract specifications.2

While the ASX's warrant and option markets offer two securities that are technically distinct, they are inextricably linked by the existence of arbitrage opportunities that arise due to their identical payoff functions. Consistent with efficient markets and the law of one price, Hasbrouck (1995) argues that the reference to 'one security' is applicable to two technically distinct but informationally linked securities governed by arbitrage possibilities. These two markets offer derivative securities that share the same fundamental characteristics such as underlying asset, strike price, expiration date, type (call or put), and exercise style, thus providing a unique opportunity to examine pricing dynamics in the two markets and to evaluate the relative importance of various price discovery hypotheses.3

In evaluating these markets and securities, the law of one price states that in an efficient market all identical goods must trade at one price. Furthermore, under the efficient market hypothesis, prices adjust instantaneously and unbiasedly to new public information. Thus, in keeping with the law of one price, as new information enters the market, price changes of related securities should be contemporaneously correlated. In this context Kim et al. (1999) propose that with market efficiency, if one security is traded in two separate markets, informed traders will be indifferent between transactions in either market, and new information will be simultaneously incorporated into prices. In practice, however, lead/lag price change relationships between markets and/or securities result from market frictions impeding the price discovery process. Chan et al. (1993) recognizing the existence of price discrepancies indicate that arbitrage trading ensures only short-lived lead/lag relationships.

The focus of this study is on the price discovery process in the Australian option and warrant markets. Specifically, we characterize both markets in terms of their respective cost structures and institutional features, and then we formally test the competing price discovery hypotheses related to trading costs and institutional environment. Findings document lower trading costs in the warrants market, although the institutional environment for trading warrants is less attractive than the environment for trading options. The empirical tests strongly support cointegrated markets thus establishing the existence of a long run equilibrium relationship between warrant and option prices. Applying an error correction model (ECM) to the data, the options market response to deviations from the long run equilibrium condition is stronger than that of the warrants market. …

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