Analysis of Warrant Data (Part 4)

The Federal Reserve began a two-day meeting on Tuesday that was expected to end with the second interest rate cut in just over a week, but market confidence in an aggressive half-percentage point drop was waning.

The Fed is mulling its next step to bolster the economy after stunning markets on January 22 with its biggest rate reduction in more than 23 years - an emergency move that brought the benchmark federal funds rate down three-quarters of a point to 3.5 percent.

Since then, investors have widely bet the Fed would keep slashing to head off a recession given worsening financial market conditions.

But after stronger-than-expected data on consumer confidence and durable goods orders on Tuesday, investors scaled back bets on a half-point move significantly.

Short-term interest rate futures showed the implied chances for a half-point cut had dipped as low as 60 percent by midday on Tuesday from 86 percent on Monday. A quarter-point cut was still fully priced in.

The Fed has been trying to minimize the impact from the subprime by cutting rate. The decision was to stabilize the market but then the market is still in a rollercoaster state. This is a good time for us to learn more about warrant and save up your cash then to jump into the market. In this post, I am going to mention two other important aspects of warrant – turnover and outstanding quantity.

Turnover is the total units of a warrant bought and sold on a day, while outstanding quantity refers to the accumulated units, or the accumulated overnight positions, held by investors (other than the issuer) at the close of trading. Outstanding percentage is the portion held by investors of the total units of the warrant in issue. I noticed this information may not be easily gathered. ShareInvestor site does have the outstanding warrant which is updated every Friday of the week and SGX also provides such information.

On a trading day when the market is dominated by day trade investors rather than overnight traders, the turnover can be way above the increase in outstanding quantity. In contrast, if all the new positions of the day are held overnight, the increase in outstanding quantity will be equal to the turnover.

Normally, when a high turnover meets a flat outstanding quantity, what we have is a day trade market. This may be a sign of a lack of confidence in the outlook for the warrant. When a high turnover meets a fall in outstanding quantity, then the market is dominated by sell orders. This may mean that the holders of a call warrant are selling on expectation that the underlying is topping out (or bottoming up in the case of a put warrant). When a high turnover meets an increase in outstanding quantity, the investors here are probably long-term players who are rather upbeat about the market outlook.

Outstanding quantity is more indicative than turnover

In comparison, outstanding quantity is a more significant indicator than turnover. Warrants that make it to the top ten in turnover may lose their followers in just a week. However, outstanding quantity tells you how many people are in the same boat as you. If we look at the price performance, together with the outstanding quantity, of a warrant, we can get a rough idea about whether it is good time to buy or whether selling pressure is building up.

Moreover, the outstanding percentage may reflect the market making the capability of an issuer. Where the outstanding percentage is too high, it shows that the issuer does not have enough holdings on hand for the purpose of price stabilization. In such a case, the warrant price may fluctuate too widely. It may even fall out of step with the underlying price. Hence, such warrants are more risky than others. For example, for a warrant with an outstanding percentage reaching 90%, the issuer will be left with only around 10% of the total units on hand. With the dwindling inventory, the issuer will find it hard to increase the supply in case the strong market demand shows no sign of ebbing. The warrant price may then shoot up to an unreasonable level due to the imbalance between the demand and supply.

In selecting warrants, investors usually focus on the strike price, maturity, effective gearing and implied volatility. Seldom do they pay attention to the outstanding quantity and percentage, which do not bear a direct relation to the value, but at times do affect the price of a warrant. Hence, investors should also know more about the outstanding quantity and percentage of their target warrants.

Reflection of market demand

Changes in the outstanding quantity of a warrant reflect the market demand, rather than the decision of the issuer. When there is an increase in demand and more investors are buying the warrant, the issuer is obliged to provide the liquidity by selling certain units in its holding to the market. Hence, the outstanding quantity will increase. In contrast, when there is a decrease in demand and more investors are selling the warrant, the issuer must buy the excess units in the market. So, the outstanding quantity will decrease.

For some warrants, their outstanding quantities grow as their trading history gets longer. Given that they have a large crowd of investors, these warrants are normally more actively traded. Investors have to be more cautious. Given the high level of outstanding quantity and the large number of participants, the prices of these warrants are subject to a stronger impact of changes in demand and supply and in market sentiment. They are therefore likely to fall out of pace with their underlying. This is particularly at times of heavy buying or selling, when huge trading volume makes it difficult for the issuer to get the market back in order quickly. While these warrants may generate a higher than expected return when they are driven to excesses, investors may also suffer a bigger loss when there is an abrupt market downturn.

How to define a high outstanding level?

Some investors may find the outstanding quantity of a warrant at a high level when it reaches a certain percentage of offer size. Actually, this is not totally correct, as the offer size of a warrant is not limited. Sometimes, a warrant may be reissued again and again, and its total offer size will be relatively large. Some investors may apply for a bigger offer size. With an expanded offer size, the outstanding quantity will of course become lower in proportion. However, this may not necessarily mean that the outstanding level is not high. Investors should refer to actual number of outstanding units as a clue. One should also be aware of the outstanding percentage. If a warrant has a very high outstanding percentage (over 80%), the issuer, with an insufficient inventory on hand, may have difficulty in maintaining the stability of its implied volatility. Hence, whenever there is an imbalance between demand and supply, the implied volatility of the warrant will overshoot, making it hard to predict its price movement.

To find out whether the outstanding level of a warrant is high or low, investors should also take note of the conversion ratio. For examples, both STI 3100 BNP ECW080328 and STI 3100 BNP EPW080328 have the same underlying, strike price and maturity. Yet for STI 3100 BNP ECW080328, the conversion ratio is 1000:1 while STI 3100 BNP EPW080328 is 770:1. Both warrants have an outstanding quantity of 40 million at point of writing. Although one of the warrants is a call and the other is a put, this does not really matter. What I wish to show here is does both of them have the same outstanding level? The answer to the question is no. In fact, the outstanding level for the put is about 1.2987 times (1000 / 770) more than the call. The reason is that each unit of the put warrant represents the right of conversion for 1/770 unit of the underlying, while each unit of the call warrant represents that right of conversion for only 1/1000 unit of the underlying. Hence, for hedging purpose, the issuer has to buy, in theory, 1.2987 times more for put warrant than that of the call warrant of the underlying or over-the-counter options.

Assuming both warrants currently have a delta of 50%. Then for every 20 million units of the call warrant sold or repurchased, the issuer has to buy/sell only 10000 units of the underlying for the hedging purpose. However, for the same quantity of the put warrant sold or repurchased, the issuer has to buy/sell 12987 units of the underlying. Although the difference between the two numbers is not very significant in this example, because I have chosen an index warrant, you will see how great the impact will be for stock warrant. Hence, when the put warrant in our example here is in heavy trading, especially around this period of time, the issuer may face a bigger problem in keeping the order and the warrant price may face a wider fluctuation.

Studying the outstanding quantity is not only helpful for warrants selection, but also indicative of the fund flows in the market. No matter what, before buying a warrant, it would be a nice idea to check out its outstanding quantity. If the level is too high, then you should be careful. In the best case scenario, the implied volatility of a warrant should hold steady after it is bought. In case the warrant’s performance turns funny (for example, the warrant price goes up although the underlying price is unchanged), it may be a sign that the market maker is losing out in maintaining the order of the market. In this case, you should sell the warrant as soon as possible to swap for another with a lower implied volatility. When it’s implied volatility finally goes down to a reasonable level, the price of the warrant will finally goes down to a reasonable level, the price of the warrant will drop even though the underlying price remains intact. This happens when the issuer has restored its holdings on hand or when other investors are selling for fear that the issuer will soon issue additional units of the warrant.

I shall continue my post on analysis of warrant data again. Chinese New Year is round the corner and I hereby take the opportunity to wish everyone a prosperous CNY.

What are Treasury Bills And How You Can Use It?

I got this email from Philips Capital and I just re-post it here. I believe some of you might have received this email as well. Before you are in a hurry to delete it, let’s spend some times to see how it can benefit us? Well, at this period of time where we are unsure which way the market is heading to, though it seems we are most likely to head towards a soft economy; this might be a good alternative fixed income investment for risk adverse investors.

Singapore Government Securities (SGS) Treasury bills (T-bills) are short-term debt securities that are issued by the Singapore Government. The tenors for Treasury bills range from as short as 7 days up to 1 year.

Treasury bills are a very useful and low risk investment tool that everyone should take advantage of.

How you can make use of Treasury bills?

Given the current yield of 1.52% p.a. (Rate is based on a 3 month T-bill and is accurate as of 23 Jan 2008.) for a 3 month T-bill, it is definitely much better than the interest given by normal saving deposits (Based on rates of UOB Passbook Saving Account, OCBC Passbook Saving Account, and DBS Auto-save (Personal) Account. Rates are taken from respective websites and accurate as of 16 Jan 2008.).

Given the flexibility of selling away your T-bills at any time, you will be able to liquidate your investment when you need the money. You can even choose to liquidate just part of it (in multiples of 1000 units).

While some fixed deposits might be offering a higher interest as a promotion, they usually require you to lock up your deposit for the entire tenure, and require a minimum investment of quite a significant sum. Unlike them, T-bills only require a minimum investment of less than $1000. If you are unwilling to lock-up a huge chunk of your funds in fixed deposits, T-bills will be suitable for you.

For equities investors, you can make use of T-bills as well. During occasions where you are staying at the sidelines, waiting for the next opportunity to make a killing, you can park your spare cash in T-bills to earn some interest. Make your money work harder for you.

How Treasury bills work?

Treasury bills have a fixed maturity date and have zero coupons. This simply means that during the tenor, the owner of the Treasury bill will not be receiving any interest payments. Instead the Treasury bills are sold at a discount and redeemed at par value upon maturity. That is why Treasury bills are also known as pure discount investment instrument.

Suppose you purchase 1000 units of a 1-year T-bill at a yield of 2%.
You will only need to pay $980 and you will receive $1000 upon maturity a year later.

Similarly for 1000 units of a 3-month T-bill at a yield of 2%, you will only need to pay $995 and you will receive $1000 upon maturity 3 months later.

To find out more on how you can start investing in Treasury bills, please visit here, email dcm@phillip.com.sg or call 6531 1555.

By the way, I do not get any benefits from Philips Capital for helping them to post this here in my blog. I just find this could be an alternative means of fixed income investment to grow your money, at least at this period of time when market is going up and down like a rollercoaster.

Analysis of Warrant Data (Part 3)

The Fed's surprise rate cut on Tuesday calmed investors a little but many were struggling to decide whether the move was a sign of salvation or of worse to come in troubled markets. Apple's disappointing results will also keep shares subdued. In fact at this point of time I am blogging, the futures of S&P 500, Nasdaq and Dow are down by approximately -20.25, -41.75 and -131 respectively. We seem to be experiencing a rollercoaster market and a good strategy to use in such a situation is to buy a call and a put to form a straddle. In that way, you reap profits when market goes either ways. What is the catch? Well, the catch is, the market must move significant enough for you to reap a profit. I will cover how we can form a straddle in one of my upcoming posts.

I would like to continue my posting on analysis of warrant data. If you have trade warrant before or you have read up on warrants trading or attended some warrants trading seminar, then I suppose you may have come across these terms such as conversion ratio, although it is also called the subscription ratio, the exercise ratio, the cover ratio, the entitlement ratio, the parity ratio, the multiplier, the set, or just the plain ratio. Whatever it is known as, this simply means the number of warrants required exercising into one share, or its cash equivalent and it could be any value.

In my post here, I will just use the term conversion ratio as a reference. The conversion ratio determines the number of warrants required for conversion into one share of the underlying stock or one point of the underlying index at maturity. For example, where the conversion ratio is 10:1 or 10 or 0.1 (1/10), depending how the issuers present their data, it means 10 units of warrants will be required to be exchanged for each share of the underlying stock.

The price of a warrant is determined by a set of terms. Even though some warrants may have the similar terms, their prices may vary. For example, two warrants may have largely the same strike price, maturity and implied volatility, but the price of one may be a few cents while the other a few dollars. Why so? Well, indeed, even for warrants with identical terms, their prices may vary hugely. This is due to their conversion ratios.

For example, STI 3300 SGA EPW080328 and STI 3300 BNP EPW080328 both have a strike price of 3300, same maturity at 28th March 2008 and approximately similar implied volatilities of 38.35% and 40% respectively at point of writing. Their conversion ratios are 590 and 1250 respectively and their last traded price are S$0.655 and S$0.315 respectively at point of writing.

From the example above, one should notice that the bigger the conversion ratio, the lower the warrant price. Although the last traded value of one warrant is approximately twice of that of the other, they are actually worth the same. If we look at STI 3300 SGA EPW080328 which has a conversion ratio of 590, one has to buy 590 units to get one share of its underlying stock upon conversion. In other words, the cost of getting one share of the stock is S$386.50 (590 x S$0.655) which is approximately S$390. In the case of STI 3300 BNP EPW080328, it has a conversion ratio of 1250 and the cost of getting one share of the stock here is S$393.80 (1250 x S$0.315) which is approximately S$390 too. Thus these two warrants are worth approximately the same. Their prices vary only in proportion to the difference in their conversion ratios and of course, in my not so perfect example here, the cost is a bit difference because of their different in implied volatility. Recall from my previous post on “Implied Volatility, Historical Volatility and Volatility Smile”, the lower the implied volatility, the lower the price of the warrant.

The point I am trying to get across above is that conversion ratio is insignificant as a performance indicator and should not be used as a reference for the price of the warrants. Instead one should look out for implied volatility as a guideline.

Psychologically, investors tend to prefer warrants with a lower price. After all, warrants of different price ranges do differ in tick movement. Accordingly, issuers have to make a choice on the conversion ratio. Yet, in theory, the difference in conversion ratio will not affect the price performance of warrants. If you understand the reason behind this, it may help enhance your chances of success.

In calculating the value at maturity and the effective gearing of a warrant at any time, the conversion ratio is always taken into account. When you are picking a warrant, do not be bothered with insignificant data such as the conversion ratio or premium. Unless you want to hold the warrant until maturity, these data should not be a matter of concern. Rather, to make sure that you are picking the right choice, you should check out carefully the other terms of the warrant, such as implied volatility and effective gearing.

I shall continue to post on warrant analysis soon.

ETF Tricks From Forbes Asia

I read this in the recent Forbes magazine and I found it is quite interesting. This is an article written by Michael Maiello on Exchange Traded Funds (ETF) in the US. An ETF is a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange, thus experiencing price changes throughout the day as it is bought and sold.

Since it trades like a stock whose price fluctuates daily, an ETF normally does not have its net asset value (NAV) calculated every day like a mutual fund does.

By owning an ETF, you get the diversification of an index fund as well as the ability to sell short, buy on margin and purchase as little as one share. Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund. When buying and selling ETFs, you have to pay the same commission to your broker that you'd pay on any regular order. One of the most widely known ETFs is called the SPDR (Spider), which tracks the S&P 500 index and trades under the symbol SPY in the US market and the STI ETF 100 which had recently undergone a stock split to become STI ETF, which tracks the STI index in Singapore.

The article discussed about some new opportunities and new hazards in this fast-changing arena. Like dandelions after a spring rain, ETFs are cropping up everywhere. Last year alone, there are some 253 launches. There are now 612 ETFs in the US, sponsored by 19 money managers, according to State Street, which manages the Spider ETF among others.

How do you choose among this vast welter? One place to start is the recommended Best Buys list extracted from the magazine as shown below.

The Best Buy formula for actively traded funds puts equal weight on costs and performance. But since ETFs are passive (usually tracking a stock index), past performance does not tell you anything useful. So the ETF Best Buys are the ones with the lowest costs in each of seven different categories of portfolios. Here the costs are defined as the sum of annual expenses and one-fifth the average bid/ask spread observed on a recent trading day.

An ETF is a cross between a closed-end fund (with a fixed number of shares outstanding) and an open end (whose sponsor continually sells shares to newcomers while cashing out departing customers).

An ETF has a fairly rigid portfolio mix. It trades, like a closed end, with a bid-and-ask spread on a stock exchange, and when you buy or sell it you run up a brokerage commission. Shares are created and extinguished in response to demand. They are created when a brokerage firm assembles a basket of constituent stocks and hands that in, getting ETF shares in return. Shares are extinguished in a reverse process that ends with the broker selling constituent stocks.

Beyond The Index

Trust manufacturers of financial products to make simple things complicated. The original ETFs tracked broad indexes like the S&P 500, however the newest aim at narrow sectors, such as banks (with a bad showing in 2007) and oil (windfalls gains of late). International ETFs are popular and enjoying since price gains; 31 overseas ETFs started in 2007.

Lately, ETF managers have hired companies like S&P and Zacks to create custom indexes for them. One such batch of ETFs was launched by Power-Shares and based on something called “Intellidexes”. These ETFs screen for stocks using 25 factors ranging from valuations to growth rates.

The PowerShares Dynamic Market ETF, the first one, has outstripped the S&P 500 since 2003 debut, scoring an annual return 14.3% return versus the S&P’s 12%. Its portfolio of 100 stocks is rebalanced quarterly, turning over the portfolio once a year, on average. The rules for picking stocks are cryptic, but this fund is an open book compared with an open-end fund. An open-end does not have to reveal its portfolio until its next semiannual report; the ETF discloses the stocks in the basket daily on the PowerShares Web site.

Some of these creatures are rather clever and so far have not slipped up. Take the Claymore/Sabrient Insider ETF, a basket of 100 stocks (adjusted quarterly) that corporate insiders are buying heavily. Since the ETF’s September 2006 debut, it is up 17% versus 13% for the S&P 500.

The newest iteration is the actively managed ETF, although it is unclear whether the US Securities & Exchange Commission (SEC) will approve the notion. The agency up to now has preferred that ETFs follow some kind of index. Bruce Bond, chief executive at PowerShares, says regulators have warned him about comparing his ETFs too closely with an actively managed portfolio.

Pending SEC approval, the proposed PowerShares Active Mega-Cap will behave just like a quant mutual fund, where various formulas kick out stock picks so the company claims that a large part of it is passively managed. Human managers will have some role, supposedly secondary.

Exchanged Traded Commodities

ETF does not necessarily have to own shares. It can own commodities or commodities contracts – the StreetTracks Gold Shares is sitting on $16.8 billion worth of gold bars in bank vaults. In the case of a curious pair of oil-related ETFs, MacroShares Oil Up and MacroShares Oil Down, the funds own, essentially, contracts with one another. They were invented by Robert J. Shiller, a Yale University economist.

The MacroShares, which first appeared in November 2006, together hold a $60 million portfolio of short-term US Treasury bonds. When the price of oil goes up, MacroShares Up gets a larger claim on the portfolio; as the price declines, it cedes value to its partner fund. Buying either half of the fund is like going long or short an oil contract on a commodities exchange.

Unlike most ETFs, which tend to trade at prices very close to their net asset values, these two years veer off. In response to popular demand, the oil-up shares were recently trading at a 9% discount to their $33.11 NAV, while the oil-downs were at 46% premium to their $10.10 NAV. (The combined $40.01 share price, however, was very close to the combined $40.45 NAV)

An advantage to the ETF as a way of speculating on commodities: it is available in small doses. An oil future on the Nymex has a contract size of 1,000 barrels, worth $99,000. Another advantage is that the ETFs do not get expire, so you can make one trade and sit on the position indefinitely. The disadvantage of these ETFs is their rapacious 1.6% expense ratio.

Dollar Cost Averaging

A popular if somewhat overrated way of investing is to buy a fixed dollar amount of an asset at regular intervals over a long period of time. You buy, say, $500 of an index fund every month for ten years. No-load funds are ideal for this style of investing, ETFs less so, because of the brokerage commissions make the ETF option at least plausible these days. Scottrade charges only $7 a trade. Bank of America offers 30 free trades per month to any customer with $25,000 in a BofA account.

If you are interested in trading ETF, you can start with the Singapore STI ETF. You can find more information here. You can also read about Gold as Investment from Wikipedia.

Analysis of Warrant Data (Part 2)

I believed by now, most of you have noticed the Singapore market had tanked more than 10% (based on the STI index) since beginning of this year. If you have read my blog earlier on regarding the “Yield Curve for Bonds” and if you have understood what the inverted yield curves really mean, and if you have read up more on warrants, I believe you may have earn quite a lot from buying the STI put warrants. One of the put warrants I was monitoring has risen more than 50% in price since beginning of this year and another is most likely going to expired in-the-money (ITM) in another 10days time. Well I am not encouraging anyone to go jump in the market and buy the STI put warrants now. The STI index has shown some signs of reversal for the last two days and some put warrants have drop in price. Give yourself some times and learn more about warrants before you embark your journey to warrant trading.

This post is a continuation of my previous post on Analysis of warrant data. Some of you might have known this already but to make it more complete, I will try not to miss out anything about warrants. What do we mean when we say a warrant or option is in-the-money? A warrant is described as in-the-money (ITM), at-the-money (ATM) or out-of-the-money (OTM), depending on the relationship between its strike price and its underlying price. A call warrant is OTM when its strike price is higher than its underlying price. In contrast, when its strike price is lower than its underlying price, the call warrant is ITM. The situation is just opposite for put warrants. When its strike price is higher than its underlying price, a put warrant is ITM; and when its strike price is lower than its underlying price, it is OTM. No matter it is call or put, if the strike is equal to the underlying price, the warrant is said to be ATM. The above is summarized below:

• In-the-money : Call warrant – Strike price less than Underlying price
• At-the-money: Call warrant – Strike price equals Underlying price
• Out-of-the-money: Call Warrant – Strike price greater than Underlying price
• In-the-money : Put warrant – Strike price greater than Underlying price
• At-the-money: Put warrant – Strike price equals Underlying price
• Out-of-the-money: Put Warrant – Strike price less than Underlying price

If we take into account the extent of the difference between the strike price and the underlying price, warrants can be further classified into ITM, deep ITM, OTM and far OTM. Generally, where there is a 15% or above difference between the strike price and the underlying price, a warrant will be considered far OTM or deep ITM. However, this 15% mark is merely a rough idea, not an absolute threshold. One must also look to the volatility of the underlying. Some warrants may be considered deep ITM or far OTM even if the difference between strike price and the underlying price is only 10% or more.

Besides classifying warrants in term of moneyness i.e. ITM, OTM or ATM, warrants can be classified accordingly to the length of their remaining days to maturity. Normally, we will describe a warrant with less than 3 months to maturity as a short-term warrant; one with 3 to 6 months left to maturity a medium-term warrant; and one with more than six months running to maturity as a long term warrant.

If we also take into account whether a warrant is ITM, ATM or OTM, a general investor may consider a medium-term warrant with around 3 months running to maturity and a strike price around 5% above or below the underlying price. More aggressive investors may go for OTM warrants with a shorter maturity. For conservative investors, they may choose ITM warrants with longer maturity.

Whether it is long-term or short term, ITM or OTM, a warrant is after all a leveraged investment instrument. Be cautious in funds allocation and stop-loss arrangements. Do not get carried away by the potential return without considering your risk tolerance.

Personally, if I am willing to invest say, SGD$400 to buy warrants, then SGD$400 is the amount I am willing to lose if I hold onto maturity and the warrant expire OTM. Hence, be very careful with your money management. If you do not intent to hold the warrant till maturity, then as a general guideline, sell off your warrants 30 days before they get expire. Another personal advice from me, although we can trade warrants like stock meaning we are able to short sell warrants, please DO NOT ever do it, unless you really know what you are doing? I will keep up with my posting on warrants soon. Have a nice day. Oh, please kindly vote in my blog too. :)

Analysis of Warrant Data (Part 1)

It’s been thirteen days since I first blog in this New Year. I must apologize for those who visit my blog and yet found nothing new to read. I have been on a holiday to Hong Kong and have been busy with work since I returned. Nevertheless, no matter how busy I can be, I would still find some times to share what I have learnt. In fact, prior to my trip, I finally found out how to model warrant pricing. I would like to share that with my readers. But before that, I would like to share more information about warrants.

Let’s first talk about decoding a warrant name. In Singapore, the two major types of warrants being traded are index and stock warrants. In particular, I’m going to discuss about covered warrants or more commonly known as structured warrants.

A warrant name is formed by a series of English letters and Arabic numbers. But, what do they actually mean? Let’s find out the answer by looking at STI3500SGAEPW080328 as an example.

1. Warrant name: STI3500SGAEPW080328
2. Underlying: STI (for Straits Times Index)
3. Strike Price: 3500
4. Issuer: SGA
5. Warrant Type: e (for European type)
6. Warrant Class: PW (for put warrant)
7. Expiry Date: 080328 (for 28th March 2008)

This is an example of an index warrant. Basically, all warrant names contain the above components. Some may have one extra English letter at the end, e.g. CAPITALANDDBECW080616A, what does it mean? The latter is an example of a stock warrant which can be decoded as follow:

1. Warrant name: CAPITALANDDBECW080616A
2. Underlying: CAPITALAND
3. Strike Price: SGD6.30
4. Issuer: DB
5. Warrant Type: e (for European type)
6. Warrant Class: CW (for call warrant)
7. Expiry Date: 080616 (for 16th June 2008)

Noticed the in the latter warrant name, we cannot find the strike price as part of the warrant naming convention. This is normally the case for stock warrant. Hence you need to find out from the issuer what the strike is or you can simply do a search at SG Warrants. In our example, CAPITALANDDBECW080616A ends with the English letter A. Others may end with B, C or D. These letters actually mean that the same issuer has issued more than one warrant, with different strike, on the same underlying with the same maturity. If you check up on the SG Warrant for CapitaLand, you will realize there is one with warrant name CAPITALANDDBECW080616 with strike price SGD7.30. In short, the letter is there to avoid any confusion that may be caused to investors. So, there is no need to be concerned too much about this extra letter. Just do not mistake a letter “C” at the end for call warrant!

After knowing how to decode the warrant name, we need to understand some of the warrant terms. The terms of a warrant include its code, name, underlying, call/put, strike price, expiry date, conversion ratio and issue price. Basically the price is determined by the terms of the warrant. The pricing of a warrant is not totally up to the issuer nor is it simply a matter of demand and supply.

Two major factors affecting warrant prices are the strike price and expiry date, which are set by the issuer before a warrant is issued. For call warrant, the lower strike price and longer the maturity, the higher the issue price of a warrant will be. A warrant gives its buyer the right to exercise it at maturity. A longer maturity means that there is a higher possibility that the holder can exercise the right. Hence, one has to pay a higher price for it. In contrast, the shorter the maturity, the less chance the right can be exercised. So, the issue price of such a warrant should be lower.

Turning to the strike price, the more in-the-money (ITM), the higher the chance for the warrant to be exercised, and the higher the warrant price will be. The same logic works on the opposite case. Hence, short-term out-the-money (OTM) warrants are normally issued at lower price, while long-term ITM warrants are issued at a higher price, provided other factors remain the same.

Apart from the strike price and expiry date, the issuer also needs to take into account any expected dividend payout of the underlying and the interest rate direction during the life of the warrant. Let us look at a call warrant again. If a high dividend payout is expected from the underlying, the warrant may be issued at a lower price. This is because the dividend received can partially offset the cost of issuance by the issuer. Accordingly, the issue price of the warrant may be set at a lower level.

In addition to these relatively more transparent data, the issuer has to consider one more factor in fixing the warrant price: the implied volatility. The issuer has to hedge against the issued units of the warrant and implied volatility is the most critical cost factor. The higher the implied volatility, the higher the hedging cost and, thus, the higher the issue price of the warrant will be. Different issuers may have different expectations on implied volatility. This is particularly so for warrants on newly-listed stocks, since there is less reference data on their volatility. As a result, such warrants may differ widely in their implied volatility. This also explains why warrants with exactly the same strike price or maturity may be issued at different prices. However, as market expectations come closer on future volatility of the underlying, the differences in the implied volatility of similar warrant will narrow, so will their price differences.

I’ll continue on my blog on warrants. I noticed prior to US market open tonight, the futures are up. Hence high chance is, the market may rally a bit tonight and hopefully the Singapore market will go up tomorrow too. Cheers!

Different Types of Warrants

Time passes really fast. 2007 is gone and now is 2008. Have you ask yourself what have you learnt this year? Have you fulfilled your resolutions for 2007? If you have, that is good for you. If you have not, try not to put what you need to do today to tomorrow again. This is my first post of 2008. I’m going to continue on my blog about warrants. I’ll discuss more about the different types of warrants.

Company warrants vs. Covered (Structured) warrants

The basic concept of warrants is to give investors the right to buy or sell the underlying at the pre-determined strike price on the pre-determined date. Company warrants and covered warrants share the same concept. Yet, there are some major differences: why they are issued? And how they are settled at maturity?

Company warrants are issued by companies to raise funds or to reward employees or shareholders. Upon maturity of a company warrant, provided the stock price is higher than the strike price at the time, the holder is entitled to buy certain number of shares of the company at the strike price. When the holder does exercise the warrant, the company must issue new shares to meet the promise. So, when company warrants are exercised, the shareholding of the company will be diluted.

Covered warrants are mainly issued by investment banks. They are issued to offer a leveraged investment tool for investors. Let’s take call warrants as an example. Upon maturity, if the underlying settlement price is higher than the strike price, the difference will be paid by the issuer to the investor. Given that cash settlement, rather than physical delivery, is the norm for covered warrants, companies will not face any changes in their shareholding structures as a result. In other words, covered warrants will not dilute a company shareholding.

Both company warrants and covered warrants are tradable on the market. However, company warrants normally have a lower liquidity, and there is no way to compare their prices. This is because the price of a company warrant is mainly determined by the board of directors. Therefore, the warrant price is very likely to deviate from the underlying price. Put another way, company warrants are less transparent and, sometimes, more speculative. In contrast, covered warrants have a good liquidity due to the market making system. Besides, their pricing mechanism is more transparent (statistics such as effective gearing is readily available). Hence, it is possible to track changes in the theoretical prices of covered warrants.

Although the concepts behind company warrants and covered warrants are similar, the two are subject to different levels of risks. Investors should study the relevant information carefully and bear in mind their own risk tolerance in making the decision whether to invest in company warrants or covered warrants.

American warrants vs. European warrants

Warrants can be divided into American or European types, based on the way they are exercised.

• American warrant – Holder can exercise the right to buy (or sell) the underlying at anytime between the listing date and the expiry date.
• European warrant – Holder can exercise the same right only at maturity.

American warrants can be exercised at any time between the listing date and the expiry date. So, they seem to be more flexible. However, in practice, few investors choose to exercise their warrants. Hence, this feature does not matter much. When we look into the issue of “time decay”, you will understand that it is often more beneficial to sell the warrant back to the market before expiry rather than holding it until the date to exercise.

In Singapore, all warrants are European type and are settled by cash rather than physical delivery. This means that if the warrants are in-the-money, the issuer will calculate and pay the difference between the settlement price of the underlying and the strike price of the warrant. Cash settled warrants are automatically exercised. So, there is no need for issuer to serve any notice of exercise.

Index warrants vs. Stock warrants

To compare index warrants and stock warrants, we can look at their difference in risk/return performance and the investment attitude.

Let’s start with the risk/return issue. The two types of warrants have basically the same structure. Their major difference is their underlying assets, and as such, the difference in their risk/return performance.

In general, an index comprises a number of stocks of different sectors and industries. Hence, its risk exposure is diversified. Its volatility reflects the weighted average volatility of its constituent stocks.

Based on conventional wisdom, when the market is bullish, investors tend to buy stock warrants. On the other hand, when the market is bearish or in a range-trade, investors tend to buy index warrants. This can be deduced by the higher trading volume of index warrants as a percentage of the total turnover when the market is on the downturn.

There are two reasons for the above. Firstly, in terms of number and variety, there are far more stock call warrants in the market. Yet, only a few, or none at all, put warrants are issued on individual stocks. In contrast, index call warrants and index put warrants are more in proportion. Secondly, when the market is climbing, investors normally expect that different stocks will take turns in leading the run. Therefore, they will focus only on the related stock warrants as they take the domino effect. Trading in index put warrants is simpler and direct investment strategy.

Of course, where investors have strong views on a particular stock, it would be better to invest in the related stock warrants. Yet, trading in index warrants might be a good idea if you want to ride on a general trend, if you are satisfied with a modest risk/return, or if you want to hedge or insure against the risks of your stock holdings on hand.

There are many difference types of warrants around, including currency warrants and exotic warrants such as dividend warrants, locked return warrants, average return warrants, spread warrants, digital warrants, knock-in warrants, window barrier warrants and straddle warrants. Given the complex settlement method of exotic warrants, one should read the terms carefully before investing. You can buy this book “School of Warrants” by Edmond Lee sponsored by Societe Generale, if you wish to learn more about exotic warrants. I’ll be away for a short trip and will be back on the 9th Jan 2008. As such, I may not be able to blog for awhile. I hereby wish everyone a happy new year 2008. May all your dreams come true this wonderful year.