Understanding Warrants

Foreword from ShareInvestor

This article “Understanding Warrants” by R Sivanithy was first published in The Business Times on 21 Mar 2005 and is reproduced in this blog in its entirety.

In last week’s column, we explained what derivatives are – basically instruments that derive their value from something else. In the Singapore stock market, warrants are the only derivative instruments that trade actively. Two types are common – ‘company issued’ and ‘structured’. Although they have some similarities, there are significant differences. In order to avoid being burnt, stock market players should be thoroughly familiar with these differences as well as all risks associated with trading warrants.

A company-issued warrant is an option to buy shares in that company for a fixed price, known as the exercise price, within a fixed time frame, usually three-five years from the date of issue. If exercised, the company issues new shares, so the number of shares in the market increases.

A structured warrant, on the other hand, is issued by a bank or financial institution and gives the holder the option to buy or sell the shares at a specified exercise price. If the option is to buy, then it is known as a structured call warrant and if the option is to sell, then it is known as a structured put warrant.

So while companies never issue put warrants on their shares, you can have third-party issuers like Deutsche Bank or Macquarie Bank issuing put warrants if there is a market demand for such an instrument.

Although similar to a company-issued warrant, the time until expiry for a structured warrant is usually much shorter, typically 6-12 months. At expiry and depending on where the underlying shares close, the issuing bank will either leave the warrant to lapse worthless or it will settle with the warrant holder in cash.

Either way, no new shares are issued, so the total number of shares in the market stays the same.

Why do people trade warrants? The main reason is the gearing or leverage benefit they offer. Suppose a company’s shares sell for $1 and as part of a fund-raising exercise, it issues warrants with an exercise price of 90 cents. The difference between the two figures, which in this case is 10 cents, is known as the intrinsic value and usually provides the base for valuing the warrant.

The reason why the intrinsic value is important is that if the warrant sells for say, eight cents, traders can buy and immediately exercise the warrant, thus ending up paying 98 cents for a share worth $1.

Since the market will not allow this to happen, we can assume that usually, the warrant will sell for at least its intrinsic value.

Now suppose the shares rise 10 per cent to $1.10. The warrant’s intrinsic value is now 20 cents ($1.10 minus 90 cents). The shares have risen 10 per cent but the warrant has risen 100 per cent.

So for a small percentage rise in the shares, the warrant rises by much more. Alternatively, you could look at it this way – for 10 cents, you gain exposure to a share costing $1. In financial terminology, you are 10 times geared, or you are enjoying 10 times gearing.

Of course, the reverse is also true – the gearing will magnify share price falls, so warrants are usually described as being inherently riskier than shares. This depends on how much money is invested in the first place – if you put all your savings in, then obviously your risks have increased significantly but if you trade carefully, it is possible that using warrants can actually reduce risk.

Notice from this example that if the shares drop below 90 cents, for instance, the warrant is intrinsically worthless and may sell for only a few cents.

What determines a warrant’s price? Intuitively, two important variables have to be the share price and the exercise price, since the difference between the two gives the intrinsic value. A third is time – the more time there is left before expiry, the greater the chances of making money and therefore the higher the price.

A fourth is interest rates, because money invested in warrants has an opportunity cost that has to be taken into consideration when valuing warrants.

So far, these four items are easily obtainable – there’s a market price for the shares, the exercise price and time are specified at the start and interest rates are freely available. The fifth variable, however, is the perhaps the most important and yet the most difficult to get.

If the underlying shares are prone to very violent movements, then the chances are good that a warrant on those shares can become profitable during its life span. If the shares are very stable, perhaps even boring performers, then chances of making money are lower. The fifth determinant of a warrant’s price is, therefore, expected volatility – the amount by which the shares can be expected to move in the future.

Since this is something that lies in the weeks and months ahead, it thus cannot be observed or easily obtained. Warrant traders, therefore, make estimates based on past data but although useful, they sometimes have limited application because the past sometimes isn’t a good representation of the future.

Students who have done basic statistics will know that volatility is measured by variability, or the standard deviation of the normal, bell-shaped curve. If so, then they’ll also know that the greater the standard deviation, the greater the risk. As such, anyone wishing to trade warrants, especially structured warrants, must familiarise themselves with all the relevant concepts.