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!