Tuesday, 1 January 2008

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.


Encik Wan said...

Thanks for the introduction of warrants. Since I am a converted long-term STI bear now, put STI warrant is my new instrument.

Neaven said...

Hi Encik Wan, you are most welcome. Let's learn and profit from this irrational market together.