Past articles: Warrants

This article appeared in Corporate page of The Edge Malaysia, Issue 781, Nov 16-22, 2009


Structured Warrants – Knowing the Product

By Jasvin Josen

Subsequent to the launch of a number of put warrants by AmInvestment Bank and OSK Investment Bank Bhd recently, much has been said about Structured Warrants. Previous writings on the product have been mainly from a standpoint of liquidity concerns and the bid-offer spread. This article will attempt to provide more insight into the product itself and their potential in Malaysia.

What is a Call and a Put

Calls give you the right to buy a share for a determined price (called the strike price) at a determined date. For example, one of OSK’s call warrants may give you the right to buy one share in ABC for RM1.00 on June 18, 2010 (that RM1.00 figure is known as the strike price). If you buy the warrant, and come mid-June 2010, ABC’s shares trade at RM1.20, you could exercise your right to buy at RM1.00 and then sell at once for the market price of RM1.20. If ABC’s shares fall to RM0.80 on June 18,2010 your warrant will be worthless. Why use your “right” to buy at RM1.00 when anyone can buy at the market at RM0.80?

Puts work in the reverse. Here, the warrant gives you the right to sell a share for a given price on a given day. Say OSK offers a put on XYZ shares that expires on June 10, 2010 at RM2.00. So when you buy that put, it gives you the right to sell XYZ at that price in eight months time, regardless of what the market price is for the share. You may buy a put warrant if you are bearish about XYZ’s prospects and you think it will move below the strike price. If you are right, then at the expiry date you could buy the share in the market, potentially for RM1.80 – and then use your right to sell it back at RM2.00. Warrants are typically settled in cash. This means that if you hold the warrant until expiry, you immediately get the cash equivalent of the transaction (RM2.00 - RM1.80).

What are Structured Warrants?

Ordinary warrants (sometimes referred to as Company Issued Warrants) are issued by the underlying companies themselves, often in conjunction with a fund raising exercise. For example YTL Corporation CG issued call warrants on its shares at a strike price of RM7.00 expiring on July 16, 2010. As the warrants get exercised, they will be converted into new shares resulting in an increase in the company’s shares. Structured Warrants are not issued by the underlying companies. They are instead issued by other issuers (investment banks like OSK, Aminvestment, CIMB). The exercise of the Structured Warrants will not have an effect on the number of shares in YTL. Intuitively, with Structured Warrants in the market, the investor will have a wider choice of companies to invest in with limited capital, for purposes of speculation or hedging.

“Structured Warrants” also seems to be a term uniquely used in Malaysia. A close equivalent that can be observed overseas is in the U.K., where they are referred to as Covered Warrants. Covered Warrants have some additional features. Bid-offer spreads on the warrants are dictated by the stock exchange rules and they are quite strict on how wide they can be. The maximum is 10% (or 1p). Investors sell back the warrants back to the issuer at the offer price that is always in existence. This is possible as the warrant issuer always hedges its exposure one way or another so the potential losses for the issuers are “covered”. The pricing of the Covered Warrant is based on a standardised model (the “Black Scholes” model which will be mentioned in Part 2) used by market practitioners. In essence, the Covered Warrant manages to overcome the problem of liquidity and pricing in the market.

How are Traded Options different from Structured/Covered Warrants

A warrant is a kind of option, only with higher liquidity and is relatively safer. From the liquidity aspect, one can sell the (covered) warrant back into the market at any time. With a traded option, you gave to go through a specialist, who then searches for liquidity.

In traded options, investors can buy or sell the call/ put. The main concern is when the investor sells the call/put, he is taking a huge risk as his downside is not limited. To illustrate this, a buyer of a call has unlimited upside when the price of the share is more than the strike price. However his downside is limited to the premium he paid when acquiring the call. No matter how the share prices fall, he only loses the premium paid. The seller on the other hand, has a limited upside (the call premium) but unlimited downside when the share price rises. Investors of Structured Warrants are only permitted to be buyers, not sellers. This ensures that our downside is limited to the premium paid. The issuers are always the sellers.

Another security feature of the Structured Warrants is that it is automatically exercised (it may be worthless or worth something at expiry) when it expires, regardless if the investor does anything.

In essence Structured Warrants are designed to be more liquid and safer as it’s aimed for the retail investor, compared to options which are targeted at institutional investors.

Future Potential for Structured Warrants

There is a promising future for Structured Warrants in Malaysia as the underlying equity market picks up and retailers get more active. Some improvements in the bid-offer spread and the pricing might be needed for discussions between the issuers and the Stock Exchange.

But with every promise there is an underlying risk that needs to be understood y the savvy investor. The article in the next issue will attempt to provide a flavour of the pricing and risk of this product.

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This article appeared in Capital page of The Edge Malaysia, Issue 780, Nov 9-15, 2009


Pricing and Risk of Structured Warrants

By Jasvin Josen

In the last issue, I explained the Structured Warrant as a product, evaluated it against similar products abroad (Covered Warrants in the U.K.) and compared Structured Warrants with traded options. This article will introduce us to the pricing and risk of Structured Warrants. It will show how the price of a warrant relates to the underlying share and go on to identify some significant features contributing to the valuation of a warrant. It will also stress some important risk aspects that an investor must be aware of.

How the price of a Warrant relates to the underlying share

Generally, a warrant’s price is closely connected to the behaviour of the underlying share. By behaviour, we primarily mean how volatile the underlying share is and whether the underlying share is moving in a favourable direction to the warrant holder. However, we must appreciate that the way that the underlying share affects the price of the warrant is not consistent. Warrants are not priced as a result of some simple balance between supply and demand (like ordinary shares). They are priced according to a formula- often some variant of the Black Scholes formulae, named after the two economists who first came up with it. The critical inputs for the formula are:

I. Whether the warrant is in, out or at the money (determined by the underlying share price and the strike price)

II. How long the warrant has until maturity

III. How volatile the underlying share is expected to be

Other less important parameters to the formulae are interest rates and dividend rates. With so many influences on a warrant’s price, it is easy to get lost. But if we master the above in simple terms, we can trade confidently.

I. What a warrant is worth (in, out or at the money)

A warrant can be “in the money”, “out of the money” or “at the money”. An example of a warrant that is “in the money” is China Construction Bank structured call warrant expiring on Nov 26, 2010 which has a strike price of RM2.268 but the underlying share is already trading at RM2.912 as at Sep 18,2009. We would expect these kinds of warrants to be more expensive. Toyota Motor Corporation –C3, an “Out of the Money” call warrant expiring on Nov 26, 2010 has a strike price of RM 135.38 when the underlying share is only trading at RM100.54. These types of warrants are likely to be trading quite cheaply. An “at the money warrant” will have its strike price very close to the underlying share price.

II. Time till Maturity – How does this affect the price of a warrant?

The right to buy/sell at the strike price, but not the obligation is always worth something, even if the warrant is not currently in the money. For example the Toyota Motor Corporation –C3 warrant mentioned above is clearly out-of-money but it’s still priced at RM0.275 at the trading date of Sep 18,2009 because no one knows what the underlying share price will be at expiry. This can be construed as the time value of the warrant.

Nevertheless, as we get closer to expiry the uncertainty falls, and the time value decays. Technically this is also referred to as the “theta”, the rate at which a warrant loses value as time passes. Time decay is not constant, and speeds up towards the end of the warrant’s life. For this reason, one must be wary of trading an out-of-money warrant that is approaching its expiry. Just by holding the warrant over a few days, one can lose money because of time decay.

III. Volatility – How does it affect the price of the warrant?

Think of share price volatility as the degree of uncertainty surrounding a share’s returns. A young biotech company share could easily rise or fall by 30%-50% in a week. In contrast, we don’t expect a stable utility company to behave in this fashion. Say we hold call warrants on both these two companies with strike prices 30% above the current share price. The higher volatility of the biotech company means that there is a better chance that its share price moves in large magnitudes leading to a higher possibility of the warrant being in the money. That is why you will find that the warrant with a higher volatility in the underlying share, costs more.

Important Risk Factors to Recognise in a Warrant

It’s imperative that investors recognise some important risk aspects in warrants. Besides the rapid time decay or “Theta” mentioned above, other important aspects are the Delta, Gearing and Elasticity.

Delta

The delta implies how sensitive the warrant price is to the movement in the underlying share price. It is measured by the change of the warrant price divided by the change in the underlying share price. However, remember that the delta says nothing about the percentage change in the warrant vs. the share price. The percentage change in the warrant price is normally larger than the share price.

Delta = change in option price / change in underlying share price

You will observe that for a warrant that is deep in the money with a few weeks from expiry, it really functions as the underlying share itself and will normally have a delta of 1.0. For example, if the underlying share rises by 10 points, we can expect this warrant to rise 10 points as well.

For an “at the money” warrant, the delta is usually around 0.5. When the underlying share price changes by 10 points, the warrant changes by only 5 points. For an “out of the money” warrant, the delta is even smaller. Any change in the underlying share price has very little effect on the warrant’s price.

Gearing

We’ve just seen that the delta does not tell you the percentage rise in the warrant that you should expect from a 1% rise in the underlying. To work this out, you need to know the warrant’s effective gearing or elasticity. All warrants are geared - owning a warrant gives you the same exposure as owning more than one share in the underlying equity, typically between 5 and 15 shares. You can calculate the Gearing by simply dividing the price of the underlying share by the price of the warrant.

Elasticity

If your warrant has a gearing of 8 and a delta of 0.5, then the effective gearing or elasticity is [gearing x delta: 8 x 0.5 = 4]. Using this example, if the underlying share goes up by 1%, the warrant will rise by 4%.

Does elasticity stay the same over the life of the warrant? Of course not, because the delta will change and so will the gearing. So it will be good to monitor the elasticity of our warrant. As the elasticity gets higher, we’d like to be more careful and closely monitor the warrant as it’s extremely sensitive. Intuitively, a “deep in the money” warrant is usually more elastic than others.

Conclusion

This series of articles have attempted to illustrate the concept of the Structured Warrant, how it behaves, significant factors that affects its price and the risks that it bears. We’ve also observed how the product can be enhanced for the retailer, with tighter bid-offer spread and model based pricing. If the savvy investor comprehends the pricing and the risk aspects of this product, it’s a very thrilling experience when he is able to make out why the price of his warrant moves in a specified manner.

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