A New Way to Value the Market

I came across this article by Geoff Colvin, senior editor from Fortune magazine, and I thought it is an interesting article to share with my readers. The article discussed about the valuation of company using the economic value added (EVA). I have reposted the article in my blog here for your reading.

Are stocks cheap yet? That slippery, eternal question is worth a look right now because a remarkable new set of data has just become available, allowing us to analyze the market in ways we never could before. I wish I could tell you that this new trove of numbers reveals that stocks are a screaming buy. It doesn't. But it does suggest that, amid all the recent tumult, just maybe the market is being rational.

The new data are derived from the most fundamental, capital-based way of analyzing a company's finances and value. How much capital is a company using? What is its return on capital? How much does the capital cost? Those questions hold the key to corporate performance, but finding the answers in most financial statements isn't easy, and many executives don't know the answers themselves. The Stern Stewart consulting firm began popularizing these concepts more than 15 years ago with the term EVA (economic value added), and the new data come from EVA Dimensions, a firm that is now the source of Stern Stewart's EVA data.

EVA-based analysis has proven extremely valuable in analyzing individual companies. I almost never make calls on specific stocks, but in late 1999 the EVA analysis of AOL was so compelling that I wrote a column declaring flatly that the stock price could not possibly be justified. That column was published on Jan. 10, 2000, right near the overall market peak (and the very day that AOL announced it was using its insanely overvalued stock to buy my employer, Time Warner (TWX, Fortune 500) - but that's another story). I also used EVA analysis to write last summer that Google (GOOGLE) was overpriced at $540; that call looked wrong for a while, though as I write this the stock is at $501.

One thing you couldn't do with EVA analysis was use it to value the whole market. Compiling the data for a significant number of companies used to take months. But now, through the miracles of our networked world, EVA Dimensions can compile it every day for 2,669 companies in the Russell 3000 (those for which at least two years of data are available). This is essentially the U.S. stock market. So: Is it worth what it costs?

Look first at how well the companies are doing at their most basic task, which is earning a return on their capital that's greater than the total cost of that capital. Turns out they've been doing very well. The dollar difference between their return on capital and cost of capital (their EVA) was $375 billion over the past four quarters. It was only half that much in 2005, and in 2004 it was negative, which isn't surprising. Over time, for the broader market, EVA should be more or less zero since competition is always forcing high returns down toward the cost of capital, while companies that can't meet their capital cost will eventually go under. So America's publicly traded companies did great last year; in fact, with economic growth strong through the third quarter, it's safe to say that they were at or near the top of the business cycle.

Next question: How are they being valued? On a recent day when the Dow closed at 12,265, the 2,669 Russell 3000 companies had a total enterprise value of $29.8 trillion (equity plus debt). To judge whether that's a lot or a little, consider that over the past four quarters these companies produced after-tax operating profits of about $1.8 trillion. Even if we assume that earnings will only match, not exceed, that level in future years, then the companies' aggregate market value today would still be $22.5 trillion (note to finance wonks: that's their profits capitalized at their capital cost of about 8.1%), which is about 75% of their actual market value.

So now we reach the central question. About 25% of the current market value of these companies is based on expectations of future profits above and beyond the profits they earned last year, at the top of the business cycle. Does that seem reasonable? Actually, it just might. The math gets a bit tedious, but you can assume no profit growth for the next several years and very modest growth thereafter, and the valuation still looks okay. Buying at today's prices may not make you rich. But - for the first time in a long time, in my view - it isn't crazy.

Analysis of Warrant Data (Part 6)

Time really flies. Today is the 7th day of Chinese Lunar New Year also known as 人日, which means it is the birthday of human beings. Therefore, I would like to wish everyone a happy birthday. This is part 6 of my posting on Analysis of Warrant Data. In this post I will talk about effective gearing and gearing.

The biggest appeal of warrant trading lies in the leverage effect. Investors only need to invest a small sum to earn a potential return or even higher than that from directly investing in the underlying. However, in picking warrant, investors often get confused with gearing and effective gearing. So, what are the differences between them? Which of them is more indicative?

Gearing

Gearing only reflects how many times the underlying costs versus the warrant. Its calculation formula is:

Gearing = Underlying Price / (Warrant Price * Conversion Ratio)

For example, the SPC call warrant, SPC RB ECW080526, has a gearing of 7.12 times at point of writing. Then an investment of S$1000 for the warrant will be equivalent to an investment of S$1000 * 7.12 = S$7120 in the underlying. However, gearing do not reflect the relationship between changes in the warrant price and in the underlying price. For example, both CAPITALAND MBL ECW080606 and CAPITALAND BNP ECW080606 have the same maturity on 6th Jun 2008, same entitlement ratio of 3:1 and approximately same implied volatility 44.65% and 46.17% respectively (I know the implied volatility is not really very close but this pair of warrant is one of the closest I can find to illustrate the effect of gearing).The strike price for the warrants are S$5.80 and S$5.98 respectively. The underlying price at point of writing is S$5.85. We can see that the warrant which is further out-of-the-money has a higher gearing of 10.54x compared with 9.51x. If an investor uses the gearing of these two warrants to work out their potential returns, they may be disappointed. The rate of increase/decrease in the warrant price relative to the underlying price is not the same as gearing. When the underlying price increases by 1%, CAPITALAND MBL ECW080606 with a gearing of 9.51x should ideally increase by 9.51% and CAPITALAND BNP ECW080606 with a gearing of 10.54x should ideally increase by 10.54% too. However, in reality, based on the data I have collected for the two warrants, CAPITALAND MBL ECW080606 increases by 20.59% while CAPITALAND BNP ECW080606 does not move a bid with the same price change movement in the underlying. We should look at the effective gearing.

Effective Gearing

Effective gearing reflects the relationship between changes in the warrant price and in the underlying price. Its calculation formula is:

Effective Gearing = Gearing * Delta

In the example I have chosen above, CAPITALAND MBL ECW080606 has an effective gearing of 5.42x while CAPITALAND BNP ECW080606 has an effective gearing of 5.52x. Then, other things being equal, for every 1% change in the underlying price, the warrant price will in theory move by 5.42% and 5.52% respectively. In my not so perfect example here, because the implied volatility for both warrants are difference which causes the warrant prices to be difference and hence the difference in Effective Gearing. In conclusion, when you invest in warrants, you should look to their effective gearing, not gearing, as a reference for their risk/return performance. Just remember that a high effective gearing can give you a higher leverage but it also means it will fall faster too when the market is in not in favor of your direction of your warrant.

Relationship between maturity and effective gearing

Maturity is negatively related to effective gearing. If we have two warrants with the same strike price but different maturity dates, the one with a longer maturity has a lower effective gearing than the other. This is because that the one with a shorter maturity has a lower time value, and thus a higher effective gearing.

ITM/OTM and effective gearing

Further OTM warrants have a higher effective gearing, because their gearing levels are higher. So, if we have two call warrants with the same maturity but different strike prices, the further OTM one will have a higher effective gearing.

One point that must be stressed here is that although the leverage effect is the biggest appeal of warrants as an investment instrument, one should never blindly go after high returns. While it is true that, generally, a higher effective gearing means a higher potential return, if you are too eager to chase after those OTM warrants which are about to expire, the risk involved can be unaffordable.

These warrants are usually less than one month away from maturity, with an over 10% gap between the strike price and the underlying price, which is extremely out of the money.

By now, most readers must have understood that one should look to the effective gearing to predict the size of change in the warrant price for every 1% change in the underlying price.

Yet, one should note that effective gearing can only reflect the theoretical change in the warrant price in response to a given amount of change in the underlying price in the near term. In fact, when the underlying price changes, the delta and gearing levels will change to, which in turn affect the effective gearing. Besides, the formula for effective gearing is based on the assumption that all other things being equal (such as implied volatility, interest rate and market supply and demand). Hence, in case these factors vary, the warrant price may fail to rise in the way suggested by the effective gearing even in the short term.

In general, premium and effective gearing go up and down together. So, a low-premium warrant has a low effective gearing, and the same goes for the opposite. In the case of a short term ITM warrant, although it carries a high delta, its effective gearing is low due to the high price tag and thus, a low gearing. Mind you, warrant trading is mainly about the leverage effect. When the effective gearing is too low, it does not mean much to invest in the warrant, which only gives you a slightly enlarged return when the underlying price moves. Yet, you are not facing less risk associated with the shortening maturity and changes in implied volatility. The risk and return are out of proportion. Besides, although such warrants have a low premium, they are not suitable for investors with a short term perspective. For a more appropriate strategy, you should first identify your target underlying and short list the relevant warrants with a comfortable effective gearing. Then, simply compare the candidates based on their implied volatility to select your right warrant.

I have been very busy this Chinese Lunar New Year and is unable to blog that regularly. I will be posting more regularly on my upcoming posts. :)

Analysis of Warrant Data (Part 5)

Hi my readers, I am sorry for not posting for awhile. I have been busy doing spring cleaning :) Now my room has once again regained its cleanliness. I am going to continue my posting on analysis of warrant.

There was an article on My Paper on the 1st of Feb 2008, which was last week, regarding option trading. I am not too sure if anyone had read about the article? In the article, there was a short mentioned about the yield curve, a methodology to peek where our economy is heading towards to in year 2008 and perhaps the next one to two years to come. In fact, last year November, I had a similar post to explain the shapes of the yield curves and its implication on the economy. That was one of the reasons I started to monitor the STI put warrants since beginning this year, but I did not trade any of them, at least not using real money. :(

Anyway, I am a novice and risk adverse investor and I do not want to jump straight into the market before I understand how warrants work for me. It is like learning how to drive. We all started on circuit then we moved on to the roads and once we are familiar with it, we can drive safely on roads. Thought that does not guarantee you will not meet up with any accidents (touch wood) but at least you are more cautious and know what to look out for. Hence I do encourage novice investors and traders who wish to trade warrants or stocks to start doing virtual trade and make it as real as possible. Once you are able to reap consistent profit from your virtual trading, then perhaps it is time for you to test out your concepts and skills in the real market. Just remember to minimize your losses and let your profits run.

I would like to continue to share what I have learnt so far in warrant trading. This post is about premium. Premium is a measure of how much the underlying price has to move for the warrant to break even if it is held to maturity.

The premium for a call warrant =

([Strike Price + Warrant Price * Conversion Ratio] – Underlying Price) / Underlying Price * 100%

Whereas, Warrant Price * Conversion Ratio is the cost of buying a warrant, and Strike Price + Cost component is the breakeven point of the warrant. In this formula, we first calculate the difference between the breakeven point and the underlying price and then divide it by the underlying price to find out the premium as a percentage.

Likewise, the premium for a put warrant =

(Underlying Price - [Strike Price - Warrant Price * Conversion Ratio]) / Underlying Price * 100%

For example, the recently listed UOB call warrant UOB BNP ECW100319 is trading at SGD$0.315 at point of writing, with strike of SGD$15.38 and a conversion ratio of 14.993:1. The underlying price is SGD$17.36 at point of writing, then the premium is

Premium = (S$15.38 + S$0.315 * 14.993 - S$17.36) / S$17.36 * 100% = 15.80%
Breakeven = S$15.38 + S$0.315 * 14.993 - S$17.36 = S$20.10

In other words, if the investor intends to hold the warrant until maturity, its takes 15.8% increase in the underlying price from its current level of S$17.36 to S$20.10 to breakeven. In this example, what we have is an in-the-money (ITM) warrant, and the underlying needs a modest increase in the underlying price to breakeven. In the case of an out-of-the-money (OTM) warrant, the underlying must make a bigger climb to reach the breakeven point.

To sum up, the premium only measures the percentage increase in the underlying price that will allow the warrant investor to breakeven upon maturity. It does not tell us whether the price of a warrant is too high or too low. Hence, unless you are prepared to hold the warrant until maturity, premium is not a relevant indicator for you.

Today is Lunar New Year eve, I hereby wish everyone 恭喜发财,万事如意.

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.