9 The Chinese Warrants Bubble.pdf

* The Chinese Warrants Bubble ? ? Wei Xiong and Jialin Yu April 20, 2009 Abstract In 2005-08, over a dozen put warrants traded in China went so deep out of the money that they were certain to expire worthless. Nonetheless, each warrant was traded nearly three times each day at substantially inflated prices. This bubble is unique, because the underlying stock prices make the zero warrant fundamentals publicly observable. We find evidence supporting the resale option theory of bubbles: investors overpay for a warrant hoping to resell it at an even higher price to a greater fool. Our study confirms key findings of the experimental bubble literature and provides useful implications for market development. 1 Introduction Asset price bubbles, i.e., asset prices that exceed assets’ fundamental values, have always been a subject of interest to economists. However, clear identification of a price bubble is challenging due to the difficulty of measuring an asset’s fundamental value. There is an open debate about whether each historical episode constitutes a bubble. For example, Garber 2000 proposes market fundamental explanations for three famous bubbles, the Dutch tulip mania 1634-37 , the Mississippi bubble 1719-20 and the closely connected South Sea bubble 1720 . Pastor and Veronesi 2006 challenge the existence of an Internet bubble in the late 1990s. The difficulty of measuring asset fundamentals makes it even more challenging to analyze economic mechanisms that drive up price bubbles. Instead, the academic literature heavily relies on laboratory settings to study asset bubbles. In this paper, we use a unique data sample from China’s warrants market to study asset price bubbles. In 2005-08, several Chinese companies issued put warrants with long maturities ranging from 9 months to 2 years. These warrants give thei