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.