Derivative warrants typically cost more than otherwise identical options, a situation that on the surface seems to defy logic. However, they are preferred by traders who trade frequently so there is something else at play besides price. Chu Zhang of HKUST and co-author Gang Li investigated and found some distinct, non-price advantages.

Derivative warrants, they show, are more liquid than options. And long-term derivative warrants offer higher short-term returns than their options counterparts.

The findings are based on a study of the Hang Seng Index (HSI) in Hong Kong, which has the worlds largest derivatives warrants market in terms of trading volume. From 2002-07, the period covered in the study, the market increased from about HK$7 billion in monthly turnover to $397 billion. Options trading grew at a much more moderate pace, from $1.04 billion per month in 2002 to $14.2 billion in 2007. This was despite the higher price for derivative warrants.

"Derivatives warrants have higher credit risk than options, so other things being equal, they should be traded at lower prices than options. But we show they tend to have higher prices than options," the authors said.

The increase in derivative warrants trading came after the HSI relaxed rules to make them more liquid, enabling an entire issue of warrants to be sold gradually rather than mostly in one lot. The minimum trading size of warrants was also kept at typically one-tenth that of options, thereby facilitating speculative trading by many small investors.

This enhancement of liquidity led the authors to look at various factors related to liquidity to test whether this was behind the price differences. They looked at bid-ask spread, trading volume, turnover ratio, contract size and the Amihud measure of illiquidity, and found derivatives to have the edge of being more liquid, and in the short term more profitable. Turnover was important to the outcome.

"It turns out that the short-term holding period returns on derivative warrants are mostly higher than for options, although derivatives were bought at higher prices. As the holding period gets longer, the return difference between derivatives warrants and corresponding options becomes narrower. Eventually, the returns on options become higher than those of derivative warrants," they said.

The period they looked at ranged from one-day holding periods to four-week ones. The convergence of payoffs under a longer holding period made the initial price paid for the option or derivative more important in terms of profitability.

"The results indicate that two assets with identical cash flows but different prices can coexist in the market if the transaction costs are different, and that the more liquid derivatives warrants market caters to the short-term trading needs of investors," the authors said.

"These investors should trade warrants because the transaction costs are lower, while investors with longer holding periods should trade options, as the returns tend to be higher due to lower initial prices."