Callable bull/bear contracts, call auction sessions, and price manipulations: Evidence from Hong Kong

• Date: 01 November 2020
• Author: Adrian C. H. Lei,Martin H. Y. Yick,Xiaorong Ma
• Published date: 01 November 2020
• DOI: http://doi.org/10.1002/fut.22105

J Futures Markets. 2020;40:1731–1750. wileyonlinelibrary.com/journal/fut © 2020 Wiley Periodicals, Inc.

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1731

Received: 23 January 2020

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Accepted: 25 January 2020

DOI: 10.1002/fut.22105

RESEARCH ARTICLE

Callable bull/bear contracts, call auction sessions, and

price manipulations: Evidence from Hong Kong

Adrian C. H. Lei

1

|Xiaorong Ma

1

|Martin H. Y. Yick

2

1

Department of Finance and Business

Economics, Faculty of Business

Administration, University of Macau,

Taipa, Macau, China

2

Department of Finance and Insurance,

Lingnan University, Tuen Mun,

Hong Kong

Correspondence

Adrian C. H. Lei, Department of Finance

and Business Economics, Faculty of

Business Administration, University of

Macau, Taipa, Macau 999078, China.

Email: adrianl@um.edu.mo

Funding information

University of Macau,

Grant/Award Numbers: MYRG2014‐0039‐

FBA, MYRG2016‐00233‐FBA

Abstract

Call auction sessions are widely adopted to improve the price discovery pro-

cess. The suspension of the closing call auction session (CAS) of the Hong

Kong Stock Exchange (HKEx) in 2009 and the reintroduction of an enhanced

CAS in 2016 provide us a unique experimental environment to assess the

effectiveness of the two different CAS models in reducing market manipula-

tion. In examining the probability of mandatory call events (MCEs) of callable

bull/bear contracts (CBBCs), we find the enhanced CAS model being more

effective in price manipulation reduction. We also find the enhanced CAS

reducing price manipulation in the preopening auction session.

KEYWORDS

callable bull/bear contracts, closing auction session, manipulation, price reversals

JEL CLASSIFICATION

G14; G15

1|INTRODUCTION

The closing call auction session (CAS), the most widely adopted mechanism to determine the closing prices of listed

equities, has been documented to improve price discovery and reduce price manipulation (e.g., Cao, Ghysels, &

Hatheway, 2000; R. P. Chang, Rhee, Stone, & Tang, 2008; Comerton‐Forde, Lau, & McInish, 2007; Hagströmer &

Nordén 2014; Hillion & Souminen, 2004; Pagano & Schwartz, 2003; etc.)

1

However, in their study of the Hong Kong

market from 2008 to 2009, Suen and Wan (2013) find that in spite of the positive impact on price efficiency, the CAS

mechanism is also more vulnerable to price manipulation attempts.

The Hong Kong Stock Exchange (HKEx) launched CAS twice with different settings. The CAS mechanism was first

introduced to the HKEx on May 26, 2008, but was subsequently removed on March 22, 2009, because of the HKEx's

concerns about market manipulation and extreme price volatility during CAS. On July 25, 2016, an enhanced CAS was

relaunched. This CAS regime has many refinements,

2

including price limit, random closing, and so forth to facilitate

market quality and restrict price manipulation. This study adopts a unique, practical, and controlled setting to revisit

1

Instead of investigating the effect of the introduction of a CAS, Y.‐K. Chang, Chou, and Yang (2019) deal with the effect of switching from a closing call auction to continuous trading.

2

The HKEx received numerous requests for an enhanced CAS model because the one it introduced in May 2008 was suspended in the following March due to the HKEx's concerns about the

appearance of abuse in the CAS and the need to maintain public confidence in the orderliness, fairness, and transparency of the market in light of unusual price movement. Accordingly, the HKEx

introduced an enhanced CAS model in July 2016. The updated version includes refinements, such as a two‐stage price limit (first stage: 5% price limit with reference to the end of the afternoon trading

session; second stage: within the highest bid price and the lowest ask price), random closing, enhanced market data transparency,and allowing at‐auction limit orders all the way to the end of the CAS.

Please refer to the HKEx's website, www.hkex.com.hk/news, for more details.

the relationship between CAS and price manipulation by investigating whether the refinement of the CAS setting helps

reduce price manipulation.

Besides CAS, which is widely covered in the media, the preopening auction session (PAS), another CAS, also

assumes manipulation risks. The opening price determines the settlement prices of certain derivatives. In the

Hong Kong stock market, the value of exchange‐traded derivatives, such as callable bull/bear contracts (CBBCs), can be

determined by the opening prices. However, to the best of our knowledge, there has not yet been a study on manip-

ulation during PAS. The CAS relaunch in 2016 allows us to examine the influences of the refinements on price

manipulation not only in CAS but also in PAS.

We focus on the CBBC, one of the most traded barrier options in the world, to study the probability of mandatory

call events (MCEs) as triggered by price changes of CBBC underlying stocks during auction sessions. The mandatory

callback feature of the CBBC provides incentives for CBBC issuers to manipulate the prices of CBBC underlying assets

to trigger MCEs (Lei, 2015). Further, since June 12, 2006, when they began to be traded on the HKEx, CBBCs have had

the largest trading volume in the Hong Kong stock market and among all stock markets.

3

The number of issued units

for CBBCs has surpassed that of derivative warrants (DWs) since 2012.

4

Thus, price manipulation is not only feasible

but also less costly given the depth and breadth of CBBC trading. We conjecture that refinements to the enhanced CAS

model are effective in reducing the price manipulation of CBBC underlying stocks in CASs and PASs.

Our results show that the enhanced CAS is more effective than the previous CAS model in constraining market

manipulation behaviors. We find that the probability of MCEs occurring during the previous CAS period is significantly

higher than that during the enhanced CAS period and that abnormal returns around MCEs are significantly smaller

during the enhanced CAS period, which supports the notion of less price manipulation of CBBC underlying stocks.

There is also evidence of less manipulation in index CBBCs.

Furthermore, our empirical evidence suggests that the introduction of the enhanced CAS model reduces the price

manipulation of CBBC underlying stocks during PAS. The probability of MCEs observed in PAS during the previous

CAS period is significantly greater than that during the enhanced CAS period. Additionally, MCEs in PAS increase the

degree of abnormal overnight return (AONR) of CBBC underlying stocks. This implies that during the previous CAS

period, the overnight price changes are larger; hence, more MCEs are observed during PAS.

The remainder of this paper is structured as follows: Section 2presents the details of CBBCs and CASs. Section 3

reviews the literature in relation to CAS and CBBCs and proposes our hypotheses. Section 4describes the methodology

and data that we use in this paper. Section 5presents the empirical results. Section 6concludes the paper.

2|BACKGROUND OF CBBCS AND INSTITUTIONAL SETTINGS

2.1 |Callable bull/bear contracts

The CBBC, also named turbo warrant, is a type of structured product with an added mandatory callback feature. The

price movement of a CBBC tends to track the price of its underlying asset closely.

5

Since 2006, CBBCs have been issued

on the HKEx either as a bull or bear contract with a fixed expiry date. The issuer is a third party (such as an investment

bank) that is independent of the HKEx and the underlying stock. The CBBC's lifespan ranges from 3 months to 5 years,

during which it will trigger the MCE and be called back immediately by the issuer once the underlying stock price

reaches the call price (barrier price) specified in the listing document. CBBCs are similar to DWs with spot price (S),

maturity date (T), strike price (X), and call price (H). A bull contract is like a call warrant with S>H≥Xand matures

with a value of S

T

−Xif the MCE is not triggered. However, when Sdecreases and reaches H, the MCE is triggered. The

contract is then settled with a residual value equivalent to max[M−X, 0], where Mis the settlement price (Lei, 2015).

6

In

3

Liu and Zhang (2011) suggest that the reason CBBCs became popular after the financial crisis is because CBBCs can closely track the price change of the underlying assets and greatly reduce the

influence of implied volatility, which meets the needs of investors seeking to avoid risk.

4

According to the HKEx Fact Books, the numbers of newly listed DWs from 2010 to 2017 are 7826, 6917, 5886, 7264, 7560, 6336, 4875, and 7989. The numbers of newly listed CBBCs from year 2010 to

2017 are 6541, 5334, 6056, 8948, 9983, 11213, 8896, and 13235.

5

CBBC investors are not required to pay the full price to own the actual underlying asset, but they can closely track the price of the underlying asset with the movement of the CBBC price (i.e., delta

close to one). If the underlying asset increases in value, a bull (bear) CBBC with an entitlement ratio of 1:1 generally increases (decreases) in value by approximately the same amount.

6

If a CBBC is not called back before its expiry, for a CBBC of a Hong Kongstock, the settlement price of the CBBC is the stock's closing price on the last trading day. For CBBC of a Hong Kong stock

index, the settlement price is the same as that of the expiring index futures contract.

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