Subsequent to the launch of a number of put warrants by AmInvestment Bank and OSK Investment Bank Bhd recently, much was said about structured warrants. This article will attempt to provide more insight into the product itself and its potential in Malaysia.
What is a call and a put?
Calls give you the right to buy a share for a determined price (called the strike price) at a determined date. For example, a call warrant may give you the right to buy one share in ABC for RM1 on June 18, 2010 (that RMI figure is the strike price).
If you buy the warrant, and come mid-June 2010 ABC’s shares are trading at RM1.20, you can exercise your right to buy the shares at RM1 apiece, and then sell immediately at the prevailing market price of RM1.20. If ABC’s shares fall to 80 sen on June 18, 2010, your warrant will be worthless. Why use your “right” to buy at RM1 when anyone can buy at 80 sen on the open market?
Puts work in the reverse. Here, the warrant gives you the right to sell a share for a given price on a given day. For instance, say the issuing investment bank offers a put on XYZ shares that expires on June 10,2010, at RM2. So when you buy that put, it gives you the right to sell XYZ shares at that price in eight months’ time, regardless of what the market price is for the shares. You may buy a put warrant if you are bearish about XYZ’s prospects and think it will move below the strike price. If you are right, then on the expity date you could buy the shares on the market. ootenuallv for RM1.80 each and then use your right to sell at RM2. Warrants are typically settled in cash. This means that if you hold the warrant until expiry, you immediately get the cash equivalent of the transaction (RM2 minus RM1.80).
What are structured warrants?
Ordinary warrants (sometimes referred to as company issued warrants) are issued by the underlying companies themselves, often in conjunction with a fund raising exercise. For example, YTL Power issues call warrants on its shares at a strike price of RM1.20 which expires on July 11, 2018. As the warrants get exercised, they will be converted into new shares resulting in an increase in the company’s shares.
Structured warrants are not issued by the underlying companies. They are instead issued by other issuers (like investment banks, such as OSK, AmInvestment and CIMB). The exercise of the structured warrants will not have an effect on the number of shares in YTL Power.
Intuitively, with structured warrants in the market, the investor with limited capital will have a wider choice of companies to invest in for speculation or hedging.
The term “structured warrants” seems to be used only in Malaysia: in the UK, they are referred to as covered warrants. Covered warrants have some additional features. Bid-offer spreads on the warrants are dictated by the stock exchange rules and they are quite strict on how wide they can be. The maximum is 10% (or 1p in the UK). Investors sell the warrants back to the issuer at the offer price that is always in existence.
This is possible as the warrant issuer always hedges its exposure one way or another, so the potential losses for the issum. are “covered. The pricing of the covered warrants is based on a standard model,such as the Black Scholes model used by market practitioners. In essence, covered warrants manage to overcome the problem of liquidity and pricing in the market.
How are traded options different from structured or covered warrants?
A warrant is a kind of option, only with higher liquidity and is relatively safer. From the liquidity aspect, one can sell the (covered) warrant back into the market at any time. With a traded option, you have to go through a specialist, who then searches for liquidity.
In traded options, investors can buy or sell the call or put. The main concern is when the investor sells the call or put, he is taking a huge risk as his downside is not limited.
To illustrate, a buyer of a call has unlimited upside when the price of the share is more than the strike price. However, his downside is limited to the premium he paid when acquiring the call. No matter how the share price falls, be only loses the premium paid. The seller, on the other hand, has a limited upside (the call premium) but unlimited downside when the share price rises.
In structured warrants, investors are only permitted to buy, not sell. This ensures that the investor’s downside is limited to the premium paid. The issuers are always the sellers.
Another security feature of structured warrants is that it is automatically exercised when it expires (it may be worthless or worth something at expiry), regardless whether the investor does anything.
In essence, structured warrants are designed to be more liquid and safer as they are aimed at the retail investor, while options are targeted at institutional investors.
Future potential for structured warrants
There is a promising future for structured warrants in Malaysia as the underlying equity market picks up and retailers get more active. Some improvements in the bid-offer spread and the pricing might be needed for discussions between the issuers and the stock exchange.
But with every promise, there is an underlying risk that needs to be understood by the savvy investor.
Source : The Edge