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Speculation Spillovers

Speculation Spillovers. Outline. 1. Motivation. 2. Results. 3. Empirical Investigation. 4. Conclusion. Motivation. Derivatives. Stabilization. Destabilization. Derivatives traders are rational and sophisticated. The impact of derivatives. Low cost High margin High liquidity.

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Speculation Spillovers

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  1. Speculation Spillovers

  2. Outline 1. Motivation 2. Results 3. Empirical Investigation 4. Conclusion

  3. Motivation

  4. Derivatives Stabilization Destabilization Derivatives traders are rational and sophisticated • The impact of derivatives • Low cost • High margin • High liquidity • Danthine (1978) • Turnovsky (1983) • Etc… • Stein (1987) • Kraus and Smith (1996) • Etc…

  5. WuLiang Put warrant Source: Xiong and Yu (2010)

  6. WuLiang Put warrant Source: Xiong and Yu (2010) 6

  7. 16 deep-out-of-the-money put warrants • The frenzied trading and spectacular bubble in the Chinese warrants market • Greater fool theory (resale option theory) • Heath et al. (1999), Poteshman (2001), Horst and Veld (2008), Haigh and List (2005), Liu, Wang, and Zhao (2010) • Behavioral bias exits in derivatives markets Xiong and Yu (2010) Other studies 7

  8. Results

  9. The spillover effect is intensified when the divergence of investors’ beliefs is more pronounced. • What are the impacts of behavioral biases in derivatives trading on the underlying asset? • The increased stock trading cannotbe fullyexplained by reasons such as information and hedging. • The underlying stocks are traded significantly more after the introduction of warrants, and the stocks are traded more extensively when the warrant speculation is more severe. • Speculation spillovers Research question Main findings

  10. Heterogeneous beliefs • Our results suggest that the resale option value of stocks increases with warrant bubbles • Resale option theory • Miller (1977), Harrison and Kreps (1978), and Scheinkman and Xiong (2003) • Two conditions: Heterogeneous beliefs and short-sale constraint • Overvaluation • A lack of knowledge about warrants contributes to the dispersion of beliefs among stock investors. (Harris and Raviv (1993) and Kandel and Pearson (1995)) • Limited attention caused by warrants introduction. (Sims (2003), • Hirshleifer and Teoh (2003), Peng and Xiong (2006), Barber and Odean (2008), Hou, Peng, and Xiong (2009), Yuan (2008)) • Short-sale constraint • Our explanation Resale option theory The links

  11. Empirical investigation

  12. WIND • We collect the complete observations of 50 warrants that are listed in Shanghai Stock Exchange and Shenzhen Stock Exchange between August 2005 and June 2008 • Warrant: warrants turnover, IPD, duration, covered or not, put dummy, etc… • Stock: stock turnover, liquidity, size, etc… • Market turnover, industry • Turnover and IPD are de-trended • Data I Source Variables

  13. Data II Mainland vs. Hong Kong 13

  14. Data III 14

  15. Event study • We formulate three pre-event periods, i.e., (-45, -15), (-90, -30), and (-180, -30), and • three symmetric post-event periods around event day 0. • The Introduction of warrants I Methodology Result I 15

  16. The Introduction of warrants II Result II 16

  17. A pooling regression • Speculation spillover Methodology Result 17

  18. Information: put warrants might convey negative information • Hedging purpose: hedge ratio • Coefficients before put dummy are significantly negative • Hedge ratio has positive sign • Still, IPD and warrants turnover are significantly positive • Why not a sample with no concern of information and hedging? • Information and hedging Concerns Result 18

  19. Warrants prices contain no information at all. • The change of hedge ratio is always zero. • Deep-out-of-the-money put warrants Advantage Result 19

  20. If the story of the resale option holds, where should we see stronger speculation spillover effect? • Smaller asset float: Hong, Scheinkman and Xiong (2006) develop a model to show that asset float (the number of tradable shares) has a large effect on the size of bubble. The implication is that there exists a negative relationship between resale option value and asset float. • Bull/Bear market: When the market is dominated by optimistic investors, it is easier to drive out pessimists. The resale option value is higher (Harrison and Kreps (1978), Morris (1996), Scheinkman and Xiong (2003), and Hong, Scheinkman and Xiong (2006)). • Behavioral explanation Test of the resale option story 20

  21. Behavioral explanation: asset float Result 21

  22. Behavioral explanation: market sentiment Result 22

  23. Conclusion

  24. Conclusion Main Findings • We find a speculation spillover effect between warrants market and stock market • We argue that the speculation spillover may be the result of increased behavioral biasesin stock trading introduced by the warrant bubble. • Our study provides a test of the resale option theory by examining the exogenousinfluence of warrant speculations on stock trading. • Our findings encourage more discussion on the design of financial derivatives in thefinancial market.

  25. Thank you

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