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The Arbitrage Opportunities on ETF Options: the Case of Shanghai Stock Exchange 50

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The Arbitrage Opportunities on ETF Options: the Case of Shanghai Stock Exchange 50 UNIVERSITY VAN AMSTERDAM BUSINESS SCHOOL MSc Finance Master Thesis The Arbitrage Opportunities on ETF Options: The case of Shanghai Stock Exchange 50 Supervisor Candidate prof. Liang Zou Mu Xu ID: 11377070 Augest 2017 This document is written by Mu Xu who declares to take full responsibility for the contents of this document. I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it. The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents. iii Contents 1 Introduction 1 1.1 Background................................1 1.2 Warrant..................................2 1.3 Differences between share warrants and options............3 1.4 ETF options................................4 1.4.1 Exchange Traded Fund......................4 1.4.2 Contract content.........................5 1.5 An overview of the 50ETF Option market performance........ 10 1.5.1 The performance of the first trading day............ 10 1.5.2 The performance of the recent trading day........... 10 2 Literature Review 13 3 Methodology 19 3.1 Generalization............................... 19 3.2 Butterfly spread.............................. 21 3.2.1 Butterfly spread using calls................... 21 3.2.2 Butterfly spread using puts................... 25 3.3 Box spread................................ 28 3.3.1 Lower boundary.......................... 30 3.3.2 Upper boundary......................... 32 iv 4 Data and descriptive statistics 35 4.1 Data selection............................... 35 4.2 Assumption of transaction cost..................... 36 4.3 Risk free rate and opportunity cost................... 38 4.4 Descriptive statistics........................... 39 5 Empirical test 41 5.1 Butterfly spread.............................. 41 5.2 Box spread................................ 45 6 Conclusion 49 6.1 Results................................... 49 6.2 Future research.............................. 51 v Summary This article briefly introduces the first option product Shanghai Stock Exchange 50 Option in the Chinese market, which is also an unusual European ETF option. This article uses butterfly spread and box spread to test the pricing efficiency of SSE50 ETF Option. The result shows that the market is substantially rational and fair. From the empirical test, we can see that the more complicated the arbitrage strategy we use, the easier we could find the arbitrage opportunities. The arbitrage proba- bility of options may have an inner relation with the remaining time to expiration. vii Chapter 1 Introduction 1.1 Background On 9th February 2015, the first option product in the Chinese financial market went public and started trading in Shanghai Stock Exchange, which is called Shanghai Stock Exchange 50 ETF Option. As the first option product in the Chinese market, this new ETF option faces plenty of uncertainties about pricing, trading volume or trader restriction. Both the possible bubble in pricing and a speculative attitude of investors might reduce the lifetime of this product. ETF options have been widely used by investors all over the world to do arbitrage or hedging especially in the American market and the European market for many years. As early as 26th April 1973, The Chicago Board of Trade established the Chicago Board Options Exchange. The first exchange to list standardized, exchange- traded stock options began its first day of trading in a celebration of the 125th birthday of the Chicago Board of Trade (Markham[1] ). After a development of more than 40 years, CBOE offers options on over 2,200 companies, 22 stock indices, and 140 ETFs. Among the four basic tools in financial derivative markets (forwards, futures, options and swaps), options have become the most active derivative product 1 1 – Introduction because of their convenience and benefits in short-selling, hedging and leverage. They are also very important in risk management and price seeking. Compared to the widely use of options in foreigner markets, the 50 ETF Option appeared quite late in the Shanghai Stock Exchange. We can clearly foresee that the Shanghai Stock Exchange 50 ETF Option would increase the market liquidity of the underlying asset, improve the structure of the ETF investors, enrich the investment strategies and also provide a new risk-free arbitrage opportunity. 1.2 Warrant There used to be a product very similar to options in the Chinese market called share warrant. In June 1992, the first allotment warrant went public in China but the trading of the share warrant was stopped by China Securities Regulatory Commission in June 1996. Also, in August 2005, to promote the reform of the shareholder structure of listed companies in China, the call warrant and the put warrant were introduced into the Chinese financial market. The shareholder structure reform connects to an endemism in China which is called split of stock shares or equity division. Chinese listed companies have a particular shareholder structure. A part of the shares, called tradable shares (most of which are public), could be traded in the market, while the other part, called untradable shares (most of which are state-owned shares and legal person shares), could not be traded in the market. At the beginning of the Chinese stock exchange, 70% of the shares could not be traded. This complicated shareholder structure fell behind the development of the financial market, so the China Securities Regulatory Commission tried to reform the shareholder structure to eliminate the differences between tradable shares and untradable shares, and the share warrant is one of the reform tools they used. In these two periods of warrant trading, big pricing bubbles and the speculative 2 1.3 – Differences between share warrants and options marketing environment became the biggest problem of the market. After the last warrant expired in 2008, there was no new warrant announced in the market any- more. In the 9 years warrant trading history, the trading volume has been as much as 2.73 trillion CNY, which is the third place in the international warrant market. Although both the share warrant and option are contracts that define the rights and obligations, these two financial derivatives have significant differences. 1.3 Differences between share warrants and op- tions On Investopedia, a warrant is defined as a derivative that confers the right, but not the obligation, to buy or sell a security, normally an equity, at a certain price before expiration1. An option is defined as a financial derivative that represents a contract sold by one party (the option writer) to another party (the option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date)2. According to the definition, both of the two derivatives endow the investors with the right to trade the security on an agreed price on or before expiration. However, the differences are quite clear. Options are standard contracts issued by a stock exchange while warrants are non-standard contracts issued by listed companies or investment banks. Furthermore, option investors could long options or short options if short selling is not banned while warrant investors could only long warrants. Regarding the impact of exercising, options will only lead to the transfer of the underlying asset among different traders, but when traders exercise the warrant, the issuer should 1Investopedia: http://www.investopedia.com/terms/w/warrant.asp 2Investopedia: http://www.investopedia.com/terms/o/option.asp 3 1 – Introduction issue additional shares as they promised on contracts, so the total equity increases. Basically, the pricing of warrants, which should be based on the price change of the underlying asset, deviates more easily from the real value. 1.4 ETF options 1.4.1 Exchange Traded Fund Before we introduce the definition of an ETF option, we should better explain the underlying asset, an ETF. ETF is an acronym that means Exchange Traded Fund. It is a marketable security that tracks an index, a commodity, bonds, or a basket of assets3. As one of the most successful equity market innovations of the past two decades, these products first appeared in 1993 in the form of Standard & Poor’s Depository Receipts (Ackert and Tian[2] , 1998). Basically, an ETF is an investment fund traded on stock exchanges, similar to stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as a stock index or bond index (Ackert and Tian[3] , 2001). The proportion of ETF in derivative markets is growing so fast because of its risk diversification, investment diversity, instantaneous arbitrage opportunities and different available risk-preferred types. The underlying asset of Shanghai Stock Exchange 50 ETF Option is the first Exchange Traded Fund in the Chinese stock market, Shanghai Stock Exchange 50 ETF (code: 510050), issued on 30th December 2014 and put into market on 23rd February 2015. The fund management company is China Asset Management Com- pany Limited with 0.5% fund management fees, and the fund custodian company is Industrial and Commercial Bank of China with 0.1% fund custodian fee. The price of this fund follows Shanghai Stock Exchange 50 index (SSE 50, code: 000016.SH), 3Investopedia: http://www.investopedia.com/terms/e/etf.asp 4 1.4 – ETF options which contains 50 sample stocks with the highest trading volume, the highest liquid- ity and the most representativeness including banking, insurance, energy, real estate firms in Shanghai Stock Exchange by “float-adjusted” capitalization. The sample stocks will be adjusted twice a year. The Fund Net Growth Rate has reached 246% after its execution. 1.4.2 Contract content Some of the basic contents of the Shanghai Stock Exchange 50 ETF Option are shown in Table 1.1.
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