1 Covered Warrants, Stock Returns and Trading Volumes: Evidence from Taiwan by Chia-Ying Chan* and Ranko Jelic** * London Metropolitan University, London EC3N 2EY, UK **University of Birmingham, Birmingham Business School, Birmingham B15 2TT, UK Corresponding author: [email protected]; tel. 44 (0) 121 4145991; fax. 44(0) 121 4146238 Abstract Covered warrants are synthetic, rather than pure, financial derivatives listed on stock exchanges like any other listed security. We examine the Taiwanese IPO market for covered warrants, and impact of the warrants’ initiations on underlying stocks’ returns, systematic risk, volatility, and trading volume. The results suggest positive, and statistically significant, price and trading volume effects associated with warrant introductions. The effects are notably different for sub-samples of the first time and subsequently listed warrants. The results of Exponential Generalized Autoregressive Conditional Heteroskedastic model (EGARCH) suggest that covered warrants introduction does not change the conditional distribution of underlying stock returns. JEL classification: G; N2 Keywords: Covered Warrants, Synthetic Financial Derivatives, Stock Market in Taiwan Acknowledgements We would like to thank Mike Theobald, participants at the European Financial Management Association Meeting – Doctoral Colloquium in London (2002), participants at seminars at University of Manchester (2003), Aston University (2003), and University of Birmingham (2004), for their helpful comments. All remaining errors are ours. 2 Introduction Covered warrants are options alike financial instruments, giving holders the right to buy or sell an asset at a specified price over a specified period. Unlike corporate warrants, covered warrants are not issued by companies on their own stocks, and no new stocks are issued upon exercise. The covered warrants, therefore, convey no information about the underlying companies’ future investment or financing policy. Unlike options, they are non-standardized contracts traded on stock exchanges like any other listed security.1 They also have much longer maturity (up to 2 years) than options. Finally, they contain a ‘covered agreement’ which stipulates that a certain amount of the underlying asset must be hold by the issuer to cover (hedge) his position. Due to the above differences, covered warrants are classed as synthetic, rather than pure, financial derivatives (e.g. options and futures).2 The status of synthetic derivatives suits trading bank mandates in many countries and allow them to issue and trade in warrants with different underlying assets (e.g. stocks, market indices, commodities, interest rate futures, etc.) without complying to 1 In some markets they are also traded over the counter. 2 There is some confusion over terminology. For example, in the Hong Kong market ‘covered warrants’ are ‘issued by companies on their own shares and result in the issuance of new equity upon exercise’ while ‘ non-collaterized’ warrants are issued by third parties on a domestic company’s shares. Exercise of non-collaterized warrants results in re-allocation of existing shares rather than flotation of new corporate equity; (Banks, 1996). In the HK literature the first type of warrants is called ‘equity warrant’ and the second type is called ‘derivative warrants.’ For the reminder of this paper, covered warrants will refer to those issued by a third party and as defined in the text. 3 sophisticated regulatory requirements and requiring a margin account. The banks normally target retail investors by selling smaller units of popular securities. The initial public offering (IPO) market for financial derivatives, opposite to the IPO of equities received relatively little attention in the literature. One of possible reasons could be that after the unexpected introduction of ‘pure derivatives’ (e.g. traded options) the subsequent listing dates are common knowledge as they are predetermined (Chan and Wei 2001). Introductions of synthetic derivatives, however, are not predetermined, one-off events. Decisions about the warrants initiation, subsequent listings and different terms of the contracts (e.g. maturity) are at discretion of issuers (numerous investment banks rather than the exchange), subject to regulatory requirements. These decisions, therefore, are expected to produce some information (surprise) effect to investors.3 In this respect, the issues of covered warrants are more similar to IPOs and seasoned equity offerings (SEOs) of ordinary shares rather than to listings of ‘pure’ derivatives. Leading international markets for covered warrants are in Germany, Switzerland, Hong Kong, Taiwan, Australia, and Italy (Figure 1 about here). Germany is the biggest market with over 25,000 issued warrants. Notable absence of US and UK from the list could be explained by developed markets for pure derivatives, and the existence of many options alike financial instruments for retail investors in these countries. For example, US long term equity anticipation securities (LEAPS), and UK spread betting, together with 3 Throughout the paper terms introductions and initiations are used inter-changeable and correspond to warrants’ announcement dates as opposed to warrants’ listing dates. 4 contracts for differences (CFDs), are main covered warrants’ competitors.4 In spite of significant trading volumes and popularity of covered warrants there is a paucity of studies examining these contracts and their interaction with underlying shares. This is compounded further by a paucity of literature examining emerging markets for financial derivatives. Figure 1 about here In Taiwan, the government’s liberalization of the local markets and the internationalization of local corporations created conditions for the development of a derivative markets in 1990s. Initially, warrants on Taiwanese companies and the market index were issued in the offshore markets by leading investment banks such as Union Bank of Switzerland, Carr Indosuez Asia, and Bankers Trust International. The Taiwan Stock Exchange (TSE) started to accept applications for the issue of covered warrants in June 1997, and the market has grown rapidly since. With 18 issuing banks, and more than 270 covered warrants, the market is the second largest in Asia (behind Hong Kong).5 The warrants are predominantly American style, on a single underlying stock, with maturity of one to two years, where parties can choose either cash settlement or physical stock delivery.6 Exercise price, maturity, and other terms of covered warrants differ among issuers, over time. This further 4 The UK covered warrants market, however, opened in 2002, and recently reached 460 listed warrants issued by more than 40 banks. 5 This includes warrants on a single underlying stock, basket of securities, and other types of (exotic) covered warrants. Leading issuers are leading domestic (e.g. Yanda, Jihsun, and Grand Cathay) and some foreign banks (Merrill Lynch). 6 Since 2003, the minimum maturity for warrants is 6 months. 5 implies existence of subsequently issued warrants, on the same underlying asset, by a number of different issuers. One of the interesting features of the Taiwanese market is that both, underlying stocks and covered warrants are listed and traded on the same stock exchange. The exchange, therefore, regulates issues and trading in both warrants and underlying assets. This is different from other covered warrant markets (e.g. Frankfurt) where warrants are, predominantly, traded over the counter. Previous studies on Taiwanese covered warrants report apparent miss-pricing of covered warrants (Lee and Hsieh, 2000; Chung et al. 2002). Mixed evidence was reported on lead lag relationship between stock and warrants prices (Zane 1998; Young 1999; Lee et al 2000), and effects of warrants’ trading volumes on underlying shares volatility (Wang 2003; Yu and Tsai 2003). Hsu and Huang (2003) report a positive price effect on 9 underlying shares for covered warrant introductions during 2000-2001 period. The objective of this paper is to examine the impact of covered warrant introductions on underlying stocks’ returns, systematic risk, volatility, and trading volume, from the market’s inception in August 1997 to February 2003. We examine a larger sample, over a longer period, than any of previous studies on Taiwanese covered warrants market.7 We also contribute to the literature by applying more robust tests for post-listing changes in stock volatility and trading volumes. We model conditional distribution of the underlying 7 The above mentioned papers, except for Chung et al. (2002), were translated from Chinese. The translated papers are, except for Yu and Tsai (2003), based on very limited samples. For example, Hsu and Wang (1999) examine 9, Zane (1999) examines 18, Young (1999) examines 3, and Wang (2003) examines 20 companies. 6 stock returns as the EGARCH process, and measure changes in trading volumes by both, trading volume ratios and abnormal trading volumes. Finally, we investigate and compare effects of first and subsequent introductions on underlying shares. We expect that differences between options and covered warrants, as well as institutional characteristics of Taiwanese market for covered warrants, may lead to different results from those reported in the previous literature on option and covered warrants listings and/or listing announcements (introductions) in other countries (Bollen, 1998; Hernandez-Trillo, 1999; Draper, 2001; Chan and Wei, 2001; Chen and Wu, 2001).8 In particular,