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Sunday 23 October 2011
Warrants: A High-Return Investment Tool
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Saturday 31 July 2010
Thursday 16 July 2009
Covered Warrants
Covered Warrants on the London Stock Exchange
In October 2002, the LSE launched a market in covered warrants. Its first year was a resounding success, with 823 new issues and trading volume of GBP97 million.
A covered warrant is essentially an option. Unlike the traditional "corporate" warrant, which is issued by the underlying company, a financial institution issues the covered warrant.
Goldman, Sachs, and JP Morgan, are notable players in this market.
Covered warrants are sometimes referred to as securitised derivatives.
Whereas the typical corporate warrants gives the holder the right to buy shares directly from the company (like a call option), the covered warrant comes in may forms:
- some (put warrants) carry the right to sell rather than to buy,
- some are based on foreign exchange or commodities rather than on stock, and,
- some have complicated exercise terms.
Characteristics of warrants
Characteristics
Warrants are often issued in conjuction with a new debt issue.
Including a warrant with the bond enables the issuing firm to float the bond issue at a lower interest rate than would otherwise be required. This may be the primary motivation for their issuance.
Warrants can be detachable and nondetachable, although the former are more important for our purposes. Detachable warrants may be sold separately from their accompanying debt issue. A nondetachable warrant cannot be sold separately.
Warrants pay no dividends, and they carry no voting rights. Their principal investment attraction is the leverage they provide; the warrant price is less than that of the corresponding common stock, and consequently warrant investments magnify the effect of stock price movements.
Warrants can have unusual exercise terms and conditions. The Standard & Poor's Stock Guide listing for many warrants indicates "terms and trading basis should be checked in detail." The majority of US warrants are from small, relatively risky firms. Newly issued warrants usually originate in conjunction with an initial public offering.
Some warrants are called "B" warrants. These come about from the exercise of an "A" warrant that allows its owner to trade the warrant for shares of stock and a "B" warrant with a higher exercise price than the "A" warrant.
Looking at warrant population by stock price range, the majority are from a firm whose stock price is low. While there may be no inherent reason why a low-priced stock should be risky, it is an empirical observation that a low stock price is frequently associated with higher relative risk.
A warrant is much like a long-term call option issued by the underlying company. The warrant holder has the right but not the obligations, to buy shares at a set price during the life of the warant. Warrants provide leverage in the same fashion as an option.
Warrants and leverage
Example:
CBrand
Number of warrants to buy 1 share: 1
Exercise price: $19.23
Expiration: 3-10-09
Warrant price: $10.00
Stock price: $27.46
Suppose someone believes that CBrand is an attractive investment and wants to put about $5000 into the company. The speculator could buy either:
$5000/$10 per warrant = 500 warrants
or
$5000/$27.46 per share = 182 shares
Suppose at the end of the warrant's life in 2009, CBrand stock sells for $40.00.
With an exercise price of $19.23, the warrants would be worth $40.00 - $19.23 = $20.77.
The holding of 500 warrants would be worth $10,385.
The 182 shares of stock would be worth $7,280.
The respective holding period returns are as follows:
Warrants: ($10,385 - $5,000)/$5,000 = 107.7%
Stock: ($7,280 - $5,000) / $5,000 = 45.6%
CBrand pays a dividend, so the value of the dividend should be included in the stock holding period calculation in order for the comparison to be fair. Shareholders are entitled to declared dividends; warrant holders are not.
Extending the life of out-of-the-money warrant
Extending the life of a warrant will immediately add value to it. A nearly worthless expiring warrant is likely to jump several dollars in value if the firm extends its life a few years.
The actual price change would depend on:
- the stock/exercise price relationship,
- the added term of the warrant, and
- the anticipated volatility of the stock over the extension period.
Pricing of Warrants (illustrations)
AR warrant.
Exercise price $7.32
Current stock price $11.95
This warrant is in-the-money.
It must sell for at least its intrinsic value of $11.95-$7.32 = $4.63, which it does.
Market price of warrant $5.00, represents a $0.37 premium over the warrant's intrinsic value.
GC warrant
4 warrants to buy 1 share at $6.60
Current stock price $19.72
What is the minimum value for which this warrant should sell?
Current stock price > exercise price by $19.72-$6.60 - $13.12.
This amount would be the intrinsic value of the warrant if each warrant permitted the purchase of one share.
Because 4 warrants are required, the intrinsic value declines proportionately: $13.12/4 = $3.28.
This amount is the minimum value at which the warrant should sell.
http://www.klse.com.my/website/bm/market_information/market_statistics/equities/downloads/warrants_info.pdf
Pricing of Warrants
The warrant is in-the-money: stock price > exercise price
The warrant is out-of-the money: stock price < exercise price.
When the warrant is in-the-money, it has intrinsic value.
Minimum, maximum and actual market values of a warrant.
If it takes one warrant to buy one shae of stock, then the effective exercise price is the same as the stated exercise price.
If however, a single warrant with an exercise price of $10 allows you to buy 2 shares of a stock, the effective exercise price is $5.
Effective exercise price = Exercise price/conversion ratio
As Standard & Poor's warns, "trading terms and basis should be checked in detail." An investor should always check the effective exercise price, which is the stated exercise price divided by the conversion ratio. It is the amount of money needed to buy one share of the stock.
Assuming a conversion ratio of 1:1, it would not make sense for the warrant to ever sell for more than the value of the underlying asset. The theoretical maximum price of a warrant is therefore equal to the stock price. (For instance, if one share of the stock sells for $25, no rational person would be willing to pay more than $25 for the right to buy a share, even if the warrant exercise price were zero.)
The theoretical minimum value is the warrant's intrinsic value. This is the greater of zero and the amount by which the stock price exceeds the exercise price. (Given a stock price of $25 and an exercise price of $20, this warrant should always sell for at least $5. If not, arbitrage would be present.)
Actual warrant prices fall between the two extremes. The gap between the market price of the warrant and its minimum value is largest when the stock price equals the exercise price. As the stock price rises or falls from this point, the gap narrows.
Understanding Warrant
WARRANTS xx07/xx16
- new ordinary share at an exercise price of RM0.40 per ordinary share.
- The exercise period is 9 years from the date of issuance which will expire on xx, May xx16.
-----
Illustration:-
Today's Share Price: 14.40
Warrant's Price: 10.80
Exercise Price: 5.30
Quantity: 60,000,000 free detachable warrants
In-the-money:
Market price of mother share > exercise price
Intrinsic value of warrant
= Market share price - Exercise price of warrant
= 14.40 - 5.30 = 9.10.
Therefore, you can exercise your right to buy the mother share at the exercise (lower) price to sell at the market (higher) price.
Premium:
Premium paid for the warrant
= Warrant market price - Intrinsic value of warrant
= 10.80 - 9.10
= 1.70
The premium paid is 1.70 (1.70/9.10 = 18.7%) over the warrant's intrinsic value.
Premiums (over the warrant's intrinsic value) are commonly used as a quick measure of the warrant's expensiveness. Because warrants are issued at a premium, investors must consider if it can appreciate to a level that allows recovery of the paid premium within the warrant's lifespan.
While warrants can offer a smart addition to a portfolio, keep in mind the following - your view of the underlying share is important; understand the unique nature of warrants and stay attentive to small movements in the market.
Cash extraction:
Assuming mother share increased to $2.00 and warrants also increased, to $1.58.
One can sell the mother share and invest some of these money into its warrants. Effectively, you would have decreased your invested capital (extracted cash of 0.42 per share) while maintaining exposure to further upside.
Including Warrant in your Portfolio
A warrant is a derivative, meaning it 'derives' its value from its underlying share. This is why the performance of a warrant will always depend on the performance of its underlying share.
A small movement in the price of the mother share can result in a surge or fall in the value of your warrant. Thus, expect this to happen and choose strategies that leverage and profit from this behavior.
Unlike a share, warrants carry an expiry date. The warrant tends to lose its value when it's close to expiring. Once it expires, it has no value and you lose the capital invested to buy the warrant. Buying and holding, as you would a share, is why 90% of warrant traders lose their capital.
If the underlying share price is above the warrant strike price (the predetermined price that the warrant holder is entitled to purchase or sell in the case of put warrant the underlying security), your call warrant is said to be in-the-money and you can exercise your right to buy the mother share at the strike (lower) price to sell at the market (higher) price.
There are costs involved when buying warrants - transaction costs and the time lag before you receive the underlying share after exercising the warrant. There're also occasions when a warrant trades at a discount. This incurs when the strike price and the cost to obtain the warrant are less than the price of the underlying share. Even tough this may look like an opportunity to make arbitrage profit, however, the risk of the underlying share price falling during the period between receiving the shares from exercising the warrant and their sale.
The whole process can take up to a month, during which the mother share can move in any direction. Warrants can also trade at a discount if the underlying share has just enjoyed spectacular run in price. Investors should avoid buying these discount warrants if they feel the high price of the mother share is unsustainable.
Warrants are the domain of short run traders. Some analysts recommend a particular trading strategy known as cash extraction. This strategy can be executed if you're holding a particular share that has appreciated in value. By selling the share and investing some of the proceeds into its warrants, you decrease your invested capital while maintaining exposure to further upside.
Many investors also trade in warrants because they sell at a fraction of the price of the underlying share and their leverage effect (a characteristic of warrants that enables the holder to enjoy larger percentage returns than the underlying security, at a lower price) allows the investors making bigger percentage gains when compared with conventional share investments.
For instance, share ABC may gain 30cent to close at $1.80, representing an increase of 20%, but a similar gain of 30cent for warrant ABC (from 50cent) to 80cent is an equivalent gain of 60%.
When the price paid for the warrant as well as its strike price is higher than the price of the underlying share, the warrant is trading at a premium. Meaning, the warrant's premium can crudely measure how much more expensive it is to acquire a share via a warrant compared with buying the share directly. Premiums are commonly used as a quick measure of the warrant's expensiveness. Because warrants are issued at a premium, investors must consider if it can appreciate to a level that allows recovery of the paid premium within the warrant's lifespan.
Another important factor to consider when selecting a warrant is volatility. A high volatility warrant, even though more expensive, can very well generate more money than a low volatility warrant. High volatility means that the underlying share is more likely making big swings.
While warrants can offer a smart addition to a portfolio, keep in mind the following - your view of the underlying share is important; understand the unique nature of warrants and stay attentive to small movements in the market.
http://ezinearticles.com/?Investing:-Warrant&id=291064