Twofish's Blog

August 21, 2006

Two recommendations for Shanghai warrants

Filed under: china, quantitative finance, quantlib — twofish @ 5:31 pm

Still thinking about this, but I already have two recommendations for Shanghai warrants.

  1. Encourage companies to issue warrants at more than two strike prices. If you have warrants at four strike prices, then you can trace out the volatility smile, and this gives you much better information about the dynamics of prices.
  2. Do not use Black-Scholes to determine the issue price. Black-Scholes wildly underestimates the value of Shanghai warrants. This has two effects, one obvious and one not so obvious. The obvious one is that the company issuing the warrants loses money. The not so-obvious one is that if the issue price of the warrant is highly underpriced then market mechanisms will fail to allocate the warrants, and so who actually gets these underpriced warrants will be determined by non-market mechanisms which are unlikely to be conducive to market transparency (i.e. the brokers friends are going to get them and flip them on the first day).

As far as what to use other than Black-Scholes, that’s what I’m thinking about. The two general ways are to use a different formula which takes into account jumps, or else use some social mechanism to derive the fair price for the warrants.

Also, I’m highly concerned of the use of stock options for employee incentives in Chinese corporations, given how they have been wildly misused in American corporations.  The problem is that in American corporations, stock options have been used essential as a means of creating “free money” and one rule of a market economy is that there is no such thing as “free money.”

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