The Pricing Models of Covered Warrants and Empirical Study in Thin Markets and Developed Markets

Abstract

The covered warrant is a financial product which is widely applied in many markets not only the thin markets such as Hong Kong, Singapore and Korea but also developed markets namely Germany, Australia, the UK and the USA. Towards the Vietnamese market, the covered warrant is a new type of investment, assisting investors in hedging and diversifying their portfolios. The occurrence of covered warrants in the next few months may increase the ranking of the Vietnamese financial market. However, in the reality, it is not easy for investors to value the price of covered warrants to make decisions. This paper aims to present three models including Binomial, Trinomial and Black-Scholes model, used to price the value of covered warrants, based on the value of their underlying assets. Moreover, based on these valuation models, the paper conducts the empirical study in thin markets (Hong Kong and Singapore) and developed markets (Australia and the UK) to select which is the best model for each type of market. The research is involved in 1,275 input data (the daily price in 6 months of 12 stocks in 4 markets) and then pricing the value of their covered warrants respectively. The research also applies the Kolmogorov-Smirnov method to test whether the stock price of underlying assets follows the log-normal distribution or not. In addition, the P-value approach is conducted to test the hypothesises. The research results indicate that the Binomial model may apply to price the value of covered warrants in thin markets, while developed markets should employ the Black-Scholes Model. Thus, this result may be a suggestion for Vietnamese investors as well as issuing organisations in selecting an approach to price the value of covered warrants. Nevertheless, the further research is required to apply for pricing covered warrants with the American-style exercise.