Actual Operation of Warrant Trading (Part 6)

This is the last post of the Actual Operation of Warrant Trading. In our last post, we will talk about the last trading day, expiry date and payout date.

If an investor waits until the maturity to ask the broker to sell his warrant holdings on hand, the instruction may be rejected. It is because that the last trading day has passed!

If it is only at the last minute that you find out the last trading day is before the expiry date, you might have lost the last chance for selling. Under the requirements of the Singapore stock exchange, the last trading day of a warrant must be the fourth trading day (excluding any Saturday, Sunday or public holiday) before its expiry date. In fact, investors may work that out for themselves with reference to the expiry date disclosed by the issuer.

Let us look at the example of SPCSGAECW081013. From the code, the expiry date is on the 13th October 2008 and the last day of trading will be on 7th October 2008 that is fourth trading day before expiry. Based on these terms, the trading came to an end after 7th October 2008.

When a warrant has expired, the issuer will transfer the settlement amount to the securities settlement account of the investor through the Central Depository (CDP). Generally, the payout date is around three working days afterwards when the money is transferred to the CDP (depending on the specific arrangements of the issuer concerned). The money will then be redirected to the investor by his or her broker or bank.

There will always be 5 valuation dates. In other words, the closing price of a valuation date may be used twice should there be a Market Disruption Event (MDE) on the previous valuation date. The Macquarie Warrant Hotshot competition begins today at 0900H, all the best for those who have sign up for the game.

Actual Operation of Warrant Trading (Part 5)

With the Macquarie Warrant Hotshot Competition starting tomorrow, it is time for me to post the last two posts on Actual Operation of Warrant Trading. In this post, we will focus on the calculation of settlement price.

The method of calculation of settlement price differs for stock warrants, index warrants and other types of warrants. In general, it is not as complicated as one might think. We will discuss only the calculation method for standard warrants. We will not be touching on the settlement for exotic warrants.

Stock Warrant

The settlement level of a stock warrant is the average closing price of its underlying for the five trading days immediately preceding the expiry date. This is true across most of the warrant issuers that I have studied. Take for example, the call warrant OCBCSGAECW080707 which is issued by Société Générale (SGA) on the underlying OCBC counter which expires on 7th July 2008 with a strike of S$8.00. The conversion ratio on this warrant is 1:3 which means we need three warrants to convert into a single OCBC stock.

The settlement calculation is computed as follow,

For call: Max { [(Settlement Price – Strike Price) ÷ Conversion Ratio ] ÷ Exchange Rate., 0 }

For put: Max { [(Strike Price - Settlement Price) ÷ Conversion Ratio ] ÷ Exchange Rate., 0 }

Based on the above formula, we need to know how to compute the settlement price so we can do the computation for the settlement at expiry.

From the screen capture above, the last five trading days prior the expiry date of the call warrant on 7th July 2008 are 30th June, 1st July, 2nd July, 3rd July and 4th July. Notice 5th and 6th July are weekends and are not consider part of trading days. The settlement price is calculated as follow, based on the closing price at the end of each trading day.

(S$8.17 + S$8.07 + S$8.15 + S$8.08 + S$8.05) ÷ 5 = S$8.104

This is above the strike of S$8.00 which is ITM and hence the settlement calculation is

Max { [(S$8.104 - S$8.00) ÷ 3] ÷ S$1.00, 0 } = S$0.034667 per warrant.

Hence if you have bought 10 lots of OCBCSGAECW080707, you will have receive a payment of S$0.034667 X 10 X 1000 = S$346.67.

Let’s take a look at the call warrant SPCSGAECW080707 on the underlying SPC counter which expires on 7th July 2008 too with a strike of S$7.88. The conversion ratio on this warrant is 1:5 which means we need five warrants to convert into a single SPC stock.

The screen capture above showed the last five trading days prior the expiry date of the call warrant. Again, the settlement price is calculated as follow, based on the closing price at the end of each trading day.

(S$6.60 + S$6.72 + S$6.83 + S$6.95 + S$6.91) ÷ 5 = S$6.802

Notice this is below the strike of S$7.88 which is OTM and hence the settlement calculation is

Max { [(S$6.802 - S$7.88) ÷ 5] ÷ S$1.00, 0 } = S$0.00 per warrant.

Hence if you bought 10 lots of SPCSGAECW080707, you will not receive anything in return.
Option trader might find the settlement of warrant is quite different from that of the option. The different being the settlement price is taken from the average of the last five trading days of the underlying rather than the last closing price of the underlying one day prior to the expiry of option.

The rationale behind such approach is to prevent anyone who has enough capital to move the stock price of the counter through market manipulation such that the warrant will become ITM at expiry. Take for example in the case of the SPC call warrant above. Suppose the strike of this warrant is S$7.00 instead of S$7.88 and if the settlement calculation is computed based on the last closing price on the trading day prior to the expiry of the warrant. If a person or an institutional investor has enough capital to buy into the SPC stock at near the closing bell of the day to push up the price of the SPC counter to be above S$7.00, say S$7.10, then for each warrant the investor holds, he or she will receive S$0.02 per warrant at settlement.

Of course this is a hypothetical situation but it is not possible in real life. Having the average of the last five trading days’ closing price as settlement price is to prevent such market manipulation from happening cause it is more difficult to move the stock price for five consecutive days than in a single time frame at closing bell. However, if the investor does have the capability to move the stock price for five consecutive days, the Singapore Exchange may already halt the trading of the underlying before further manipulation happens.

Index Warrant

The settlement level of an index warrant differs across different issuers. I have listed the method of settlement for the Straits Time Index (STI) for various issuers below based on my findings.

1. For Société Générale (SGA), the settlement for the STI is based on the final settlement of the future contract of the STI. The future contract settlement for STI can be found here.
2. For Deutsche Bank (DB), the settlement for the STI is based an amount equal to the reference level on the valuation date or an amount equal to the arithmetic average of the reference levels on all the valuation dates, as determined by the issuer and without regard to any subsequently published correction.
3. For BNP Paribas (BNP), the settlement for the STI is based on the five days average closing price of STI.
4. For Macquarie Capital Securities (MBL), there is no warrant issued for STI that I can find.
5. For Rabo Bank (RB), I cannot find any settlement details on how they compute for both equities and index.

The formulae used to compute the settlement calculation for index is the same as the ones used to calculate for stock. For example, the settlement for put warrant STI3200SGAEPW080627 on the underlying STI which expires on 27th June 2008 with a strike of 3200 and conversion ratio of 500 is as follow,

Max { [(3200 – 2947.8) ÷ 500] ÷ S$1.00, 0 } = S$0.504400 per warrant.

The settlement level 2947.8 is gotten from the Singapore exchange website. See the screen capture below.

Please do take note that the settlement for HSI index listed in Singapore exchange by various issuers may have a different settlement procedure compared with STI. I have listed the links below where you can find the calculation of the settlement for all the expired warrants by different issuers.

1. For Société Générale (SGA), the settlement details can be found here.
2. For Deutsche Bank (DB), the settlement details can be found here.
3. For BNP Paribas (BNP), the settlement details can be found here.
4. For Macquarie Capital Securities (MBL), the settlement details can be found here.
5. For Rabo Bank (RB), I cannot find any settlement details on how they compute for both equities and index.

I hope this post has given my readers an idea on the settlement for both Singapore equities and Index. The same formula can be used to compute for plain vanilla warrants issued on equities or index in Hong Kong or Japan. We just need to pluck in the exchange rate in this case and also find out on how the settlement level is determined.

Exploring the Precursor to Straight Through

I miss out the portion on Straight Through Processing (STP) earlier on and take the opportunity now to post it here, thanks to Shashank Mahajan who reminder me. I seriously didn’t expect someone from New York to be reading my blog. Thanks for your support.

To understand STP, you need to understand the concepts of the front office, middle office, and back office. These are, role-wise, the segregation in a member’s office or trading institution’s office.

The front office is responsible for trading. In a broker’s office, the front office speaks to various customers and solicits business. The front-office staff is also responsible for managing orders and executing them.

The back-office staff is responsible for settling transactions. The back office ensures that all obligations toward the clearing corporation are met seamlessly and that the member receives its share during pay-out.

While this entire process is happening, the middle office monitors all limits and exposures, and thus risks that the firm is assuming. The middle office is also responsible for reporting, especially where corporate-level reporting is required.

Since a broker’s office is organized into front, middle, and back offices, solution providers structure their products in the same fashion in the form of modules. Although many vendors provide solutions for all three sections, it is not mandatory for a broker to buy all three modules from the same vendor. If a broker goes for different vendors, though, then they have an issue of inter-module communication. Most brokers want all the three modules to be integrated. If they are not, then data will have to be entered multiple times in these modules. To obviate from this problem, brokers rely on a concept called STP.

STP, as defined by the Securities Industry Association (SIA), is “...the process of seamlessly passing financial information to all parties involved in the transaction process, spanning the investment manager decision through to reconciliation and statement production, without manual handling or redundant processing in real time.”

Two types of STP exist: internal and external. In the case just discussed, internal STP is required because you need to connect modules installed in a broker’s office. But some other entities such as custodians, fund managers, and so on, play an equally important role in settlement. To achieve true STP, even these need to be connected to each other. Any attempt to connect such entities beyond the organization in pursuit of STP is called external STP.

The industry wants to put processes in place that will allow an order to flow right from deal entry to conversion to trade to affirmation and confirmation and finally through settlement and accounting without manual intervention. This is because the industry wants to move toward T+1 settlement. This means trades done on one day will get settled the next day. This is an ambitious plan because it will call for a lot of process change, technology change, and industry change. Applications will have to come together and orchestrate the entire business process.

STP provides a lot of benefits to industry participants:

• STP reduces settlement time. This essentially reduces risk because transactions will be settled faster and will be irrevocable. Settlements are said to be irrevocable when they are considered to be final and cannot be reversed. Reduced settlement time also means better utilization of capital.
• Less manual intervention will mean fewer operational risks and errors. It will also mean fewer costs.
• STP will force the entire industry to move toward standard communication protocols. This will mean standardized systems and fewer system development and maintenance costs. Interoperability will be a prerequisite for this to happen.
• Increased automation will lead to increased throughput in transaction processing, thereby enabling institutions to achieve greater transaction volumes.

Equity trading and STP by itself are vast subjects, and understanding every minute business detail in a single go is not possible; furthermore, the functioning of every stock exchange is different from one another (though the concepts are fairly standard).