Twofish's Blog

June 16, 2006

What I’m researching

Filed under: china, quantitative finance — twofish @ 6:04 pm

My research right now consists of the valulation of stock warrants on the Shanghai exchange. The basic problem is that the models most people are using assume that the stock takes a Gaussian random walk, and don't take into account the possibility of a sudden jump. There are models that do take into account sudden jumps, but there is a wrinkle that makes them hard to apply to Shanghai.

In most Western markets, you have options that are at every price of the stock. By plotting out the value of those options, you get a curve called the "volatility smile" which you can use to model the probability of sudden jumps. In Shanghai, you have only warrants at two prices (and how that works involves going into the details of Chinese securities and contract law), and you can't figure out a complete curve. What I'm trying to do right now is to use the fact that the stock prices change to get other points on the curve.

Now once I get that, the next step is to think about more efficient ways of hedging warrants. Right now, securities regulations require covered warrant issuers to be able to cover the price of the warrant no matter what happens (the technical term is "superhedging"). This is highly inefficient and ties up a lot of capital, but also necessary because securities companies don't have good risk management (because no one knows how to model these warrants) and because Chinese securities companies unlike Western investment banks tend to be very short on capital that they can use go cover a major loss.

(I'm skipping over a lot of details. If you want me to go into a huge amount of excruiating detail, ask.)

One thing that I really would like is to get in contact with someone that actually trades these warrants. The main piece of knowledge I'm missing is why someone would want to buy a put or call warrant in the first place, other than for naked speculation. Also, I'm curious about the Chinese steel industry. The two warrants I'm most familar with Baotou Steel and Wuhan Steel are both steel companies. Why are steel companies interested in issuing warrants?

(Also, if you are a hedge fund, here is an idea. The problem with some Chinese industries like steel is that they are small and have poor economies of scale. There is likely to be huge boosts in efficiency and productivity with some mergers and accquisitions. The big barriers to this are that mechanisms similar to anti-trust need to be worked out, also mechanism for diversified ownership of SOE's need to be worked out, also you need to figure out what to do about all of the potentially unemployed people or massive overproduction that may result if you make things more efficient. )

Right now the main thing I'm doing is to create an open source programming environment using R and QuantLib that I can do this research in, and I really need to focus on that for a few days and put thinking about courseware licenses or Chinese bureaucracies on the back burner.

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