Greatest Care must be taken in Buying Convertible Bonds

Some common popular bonds in the market in recent years are the

• convertible issues and 
• bonds with warrants to buy stock attached.

Convertibles are popular because they seem under certain conditions to combine 

• a degree of bond dollar safety 
• with a chance of profit.

Profits can be made by careful selection, pricing and timing of these bonds.

Market price of convertible bonds

The market price of a convertible bond is a 

• combination of estimated true current investment value
• plus a premium for the current value of conversion privilege, if any.  

This premium varies with 

• the estimated opportunity to make a profit, 
• the length of time the privilege runs and 
• other factors.

The greatest care must be taken in buying convertibles.

The most common mistake is to look too closely into 

• the size of the premium or 
• the closeness of the conversion price on the bond to the current market for the stock into which it can be converted.

You should look first into the stock for which it can be exchanged.

• If you care to make a profit, this must go up.  
• You must start by being fundamentally bullish on the equity.  
• Only then can you look into the mathematical factors governing the price of the convertible bond.

Warrants

A warrant is somewhat similar to a conversion option, but it is not embedded in the bond's structure.

It offers the holder the right to purchase the issuer's stock at a fixed exercise price until the expiration date.

Warrants are attached to bond issues as sweeteners, allowing investors to participate in the upside from an increase in share prices.

Stocks and Bonds

The balance sheet helps us understand the overall financial health of a company.

A major factor in determining financial health is the company's underlying capital structure.

What is the best way to capitalize a company?  Is it equity or debt?  The answer is that it depends, as both debt and equity have their advantages.


Debt

Debt offers the following advantages.

1.   Lenders have no direct claim on future earnings.  Debt can be issued without worries about a claim on earnings.  As long as the interest is paid, the company is fine.

2.  Interest paid on debt can be deducted for tax purposes.

3.  Most payments, whether they are interest or principal payments, are usually predictable, and so a company can plan ahead and budget for them.

4.  Debt does not dilute the owner's interest, and so an owner can issue debt and not worry about a reduced equity stake.

5.  Interest rates are usually lower than the expected return.  If they are not, a change in management can be expected soon.



Debt securities can take a number of different forms, the most common being bonds.

Bonds are obligations secured by a mortgage on company property

Bonds tend to be safer from the investors' standpoint and therefore pay lower interest.

Debentures, in contrast, are unsecured and are issued on the strength of the company's reputation, projected earnings, or growth potential.

Debentures, being far riskier, tend to pay more interest than do their more secure counterparts.




Equity

Equity has the following advantages:

1.  Equity does not raise a company's break-even point.  A company can issue equity and not have to worry about achieving performance benchmarks to fund the equity.

2.  Equity does not increase the risk of insolvency, and so a company can issue equity and not have to worry about any subsequent payments to service that equity.  Equity is essentially capital with unlimited life and so a company can issue equity and not have to worry about when it comes due.

3.  There is no need to pledge assets or offer by personal guarantees when equity is issued.



Equity can take a number of different forms.

A simple form of equity is common stock.

This type of stock offers no limits on the rate of return and can continue to rise in price indefinitely.

There are no fixed terms; the stock is issued and the holder bears the stock.

Preferred stock entitles the holders to receive dividends at a fixed or adjustable rate of return and ranks higher than common stock in a liquidation.

Preferred stock may have anti-dilution rights so that in a subsequent stock offering, preferred stockholders may maintain the same equity stake.

Convertible securities are highly structured in nature and are based on certain parameters.  As the word convertible indicates, they may convert into other securities.

Among the most common are warrants and options.

Warrants and options stand for the right to buy a stated number of shares of common or preferred stock at a specified time for a specified price.

There are also convertible notes and preferred stock, which refer to the right to convert these notes to some common stock when the conversion price is more favourable than the current rate of return.

Maybank Investment Bank issues 16 new call warrants

 November 6, 2015, Friday

KUALA LUMPUR: Maybank Investment Bank Bhd has issued 16 European style cash-settled call warrants over ordinary shares of Bumi Armada Bhd, Dayang Enterprise Holdings Bhd, Dialog Group Bhd, Petronas Chemicals Group Bhd, SapuraKencana Petroleum Bhd and UMW Oil and Gas Corporation Bhd.

The warrants will be listed today with an issue size of 100 million each, the investment bank said in a statement yesterday.

It said the issuance targets sophisticated investors looking to profit from the volatility of the oil and gas sector following the US Federal Reserve’s decision to hold an interest rate hike, thus contributing to the market uncertainty which impacted the global currency market.

“This is a contributing factor that could drive up the volatility of share prices in the oil and gas sector,” it said.

Furthermore, it said, a proposal by Venezuela to reduce oil production and boost oil prices in a recent Organisation of Petroleum Exporting Countries (OPEC) meeting also did not go through, and industry players would be looking to the next OPEC meeting, expected on Dec 4, for some guidance. — Bernama

Read more: http://www.theborneopost.com/2015/11/06/maybank-investment-bank-issues-16-new-call-warrants/#ixzz3qwgGM05i

Local Index Warrant: Calculation of Settlement Price

The method of calculation of settlement price differs for stock warrants, index warrants and other types of warrants.


Local Index Warrants

The settlement level of an Index Warrant is the final settlement price of the index.



Settlement level of an Index Call Warrant:

Index Call Warrant = (Settlement Level - Strike Price) / Conversion Ratio

For example, the key terms of a XYZ Call Warrant are as below:

Underlying   XYZ Index (XYZ)
Warrant Type   Call
Strike Price  2,300
Maturity Date 29.12. 2016
Conversion Ratio 200

The settlement level of this warrant will be the final settlement price of the XYZ Dec 2016 Futures Contract on 29 Dec 2016.

If the settlement level of the XYZ is 2,500, then the settlement amount of this warrant will be:

= (2,500 - 2,300) / 200
= $ 1.00 per unit


Settlement level of an Index Put Warrant

Index Put Warrant = (Strike Price - Settlement Price) / Conversion Ratio

For example, the key terms of a XYZ Put Warrant are as below:

Underlying   XYZ Index (XYZ)
Warrant Type  Put
Strike Price  2,200
Maturity Date  29 Dec 2016
Conversion Ratio 200

The settlement level of this warrant will be the final settlement price of the XYZ Dec 2016 Futures Contract on 29 Dec 2016.

If the settlement level of the XYZ is 1,900, then the settlement amount of the above warrant will be:

= (2,200 - 1,900) / 200
= $ 1.50 per unit.

Decoding a Warrant Name

Warrant Name
Underlying
Strike Price
Issuer
Warrant Type:  European or American
Warrant Class:  Call Warrant or Put Warrant
Expiry Date


Other Terms
Warrant Price
In the Money/At the Money/Out of the Money (Strike Price > or = or < Underlying Price)
Maturity: Short Term < 3 mths, Medium Term 3 to 6 mths, Long Term > 6 mths
Underlying Price
Days to Maturity
Implied Volatility
Interest Rates
Dividend
Historical Volatility
Conversion Ratio
Turnover
Outstanding Quantity
Premium:  positive, negative (discount), shrinking
Effective Gearing
Gearing
Delta
Vega, Gamma, Rho
Tick value
Face value
Bid/Ask Spread
Settlement Price

Stock Warrants:  Stock Put, Stock Call
Local Index Warrants:  Index Call Warrant, Index Put Warrant
Foreign Index Warrants:  Call or Put
Currency Warrants

Last Trading Day
Expiry Date
Payout Date

Warrants: Option Pricing Model

An example:

Warrants: Turnover versus Outstanding Quantity

Turnover is the total units of a warrant bought and sold on a day.

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.



Various scenarios and interpretations of the market.

Day Trader >>> Overnight Traders  -  Turnover >>> Outstanding quantity

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.


All new positions held overnight - Turnover = 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.


Day trade market - High turnover + Flat outstanding quantity

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.


Market dominated by sell orders - High turnover + Fall in outstanding quantity

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).


Players are upbeat about the market outlook - High turnover + Increase in outstanding quantity

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.

Warrants: Historical Volatility

Historical volatility reflects the historical price of a stock within a given period of time.

If Stock A is trading at $10 with a volatility of 10%, then based on the theories of statistics, there is

-  68% of the time that the stock will be trading within the range of $9 to $11 ($10 +/- 1 S.D.),
-  95% of the time within the range of $8 to $12  ($10 +/- 2 S.D.)and
-  99.7% of the time within the range of $7 to $13  ($10 +/- 3 S.D.).

In other words, the higher the historical volatility of the underlying, the higher the level of its future volatility will be in a given period of time.


For the investors
Investors can use historical volatility to predict the future volatility and price direction in order to formulate their investment strategies.

For the issuer
For the issuer, historical volatility is one of the factors they need to take into account in determining the price of a warrant.
Where the historical volatility of its underlying is high, a warrant is likely to be issued at a higher price. However, past performance may not indicate future trends.
Hence, in the pricing process, an issuer will alos find out what the markte expects of the future volatility of the underlying, that is what we call the "implied volatility" of the warrant.

Warrants: Implied Volatility and Warrant Price

Apart from the underlying price, the most important factor that affects the price of a warrant is implied volatility.

It is the expected volatility of the underlying in a given future period of time and is positively related to the warrant price.

When the implied volatility of a warrant increases, its price may go up.

When the implied volatility decreases, the warrant price may go down.




An example:

Stock A is currently trading at $10.  The market expects that the range of fluctuations of the stock will be within $1 for most of the time in the future.

Stock B is currently trading at $10, and the market expects that its range of fluctuations will be within $5 for most of the time in the future.

What is the probability that stock A will climb to $20 within 6 months?

Which one, between Stock A and Stock B, will have a better chance of hitting $20 in 6 months?

Obviously, the answer is Stock B.


If for some reasons, the market expects a drop in the volatility of  stock B (say from $10 to $1 in terms of the range of fluctuations) in a given period of time, then the price of a related warrant may go down as well.

This is due to the lower probability that the price of Stock B will exceed the strike price of the warrant upon maturity.

Hence, there is less chance for the warrant to be exercised upon maturity, and the investor will also have a less chance to get a higher return.  As a result, the warrant price is likely to fall.

American Warrants versus European Warrants

Warrants can be divided into American or European types, based on the way they are exercised.

American Warrant - Holder can exercise the right to buy (or sell) the underlying at any time between the listing date and the expiry date.

European Warrant - Holder can exercise the same right only at maturity.



American Warrant

American Warrants can be exercised at any time between the listing date and the expiry date.

They seem to be more flexible.  However, in practice, few investors choose to exercise their warrants and hence, this feature does not matter much.

It is often more beneficial to sell the warrant back to the market before expiry rather than holding it until the date to exercise (the issue of "time decay").


European Warrant

European Warrants are settled by cash rather than physical delivery.

This means that if the warrants are in the money, the issuer will calculate and pay the difference between the settlement price of the underlying and the strike price of the warrant.

Cash settled warrants are automatically exercised, there is no need for the issuer to serve any notice of exercise.

Warrants: Conversion Ratio

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, 10 units of warrants will be required to be exchanged for each share of the underlying stock.

Even for warrants with identical terms (same strike price, maturity and implied volatility), their prices may vary hugely.

These warrants are worth exactly the same.  Their prices vary in proportion to the difference in their conversion ratios.

The price of one may be a few cents while the other a few dollars.  This is due to their conversion ratios.

The bigger the conversion ratio, the lower the warrant price.



Conversion Ratio is Insignificant as a performance indicator

Psychologically, investors tend to prefer warrants with a lower face value.

After all, warrants of different price ranges do differ in tick movement.

In theory, the difference in the conversion ratio will not affect the price performance of warrants.

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.

(In calculating the value at maturity and the effective gearing of a warrant at any time, the conversion ratio is always taken into account.)

Technical Parameters of Warrants: Vega, Gamma and Rho

Vega

Vega measures the rate of change in the warrant price for each point of movement of its implied volatility.

No matter it is a call warrant or a put warrant, vega is always positive, indicating that the warrant price and its implied volatility always move in the same direction.

Vega can be an absolute value or a percentage relative to the warrant price.


Gamma

Gamma measures the sensitivity of the delta of a warrant to the price movements of its underlying.

The higher the gamma, the bigger the change in delta will be in reaction to a movement in the underlying price.

Gamma = Rate of Change of Delta / Rate of Change of Underlying Price

No matter it is a call warrant or put warrant, gamma is always positive.



Rho

Rho measures the sensitivity of warrant price to changes in the market interest rate.

Call warrants have a positive rho, meaning that the price of a call warrant moves in the same direction as the market interest rate.

In contrast, put warrants have a negative rho, and this shows that the price of a put warrant moves in the opposite direction to the market interest rate.

Given that changes in interest rates tend to be limited in the short term, their effect on warrant prices is minimal.

Technical Parameters of Warrants: Theta

Theta, also called time decay, measures the rate of change in the price of a warrant as its maturity is running short while all other things being equal.

It can be expressed as an absolute value or a percentage relative to the warrant price (theta / warrant price).

Unless in some special circumstances, the value of theta is usually negative, reflecting the declining value of a warrant as time passes.

Depicted in a chart form, the slope of the curve of time value becomes steeper as the warrant gets closer to its maturity.

This shows that time decay accelerates as time passes.


Additional notes:

In percentage terms, time value has the biggest impact on out of the money (OTM) warrants.

The value of a warrant consists of intrinsic value and time value.

They vary in absolute and relative terms for warrants with different strike prices and maturity dates.

In the case of OTM warrants, their intrinsic values are negligible.

In other words, time value makes up most of their values.

Hence, they are more sensitive to the passage of time.

As for in the money (ITM) warrants, given that a large part of their value is made up of intrinsic value, they are less sensitive to the passage of time, and such sensitivity decreases as the maturity date gets nearer.

Warrants: Effective Gearing versus 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 close to or even higher than that from directly investing in the underlying.



Gearing

Gearing only reflects how many times the underlying costs versus the warrant.  

Its calculation formula is:

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



Effective Gearing

However, the rate of increase/decrease in the warrant price relative to the underlying price is not the same as gearing.

To estimate the increase/decrease in the warrant price relative to the underlying price, we should look to the 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  x  Delta

For example, the effective gearing of a warrant is 10 times, then, other things being equal, for every 1% change in the underlying price, the warrant price will in theory move by 10%.

Put simply, delta measures how much, in theory, the warrant price will move for a $1 change in the underlying price.

When you invest in warrants, you should look to their effective gearing, not gearing, as a reference for their risk/return performance.

Warrants: Days to Maturity

Warrants can be classified accordingly to the length of their remaining days to maturity.

Short term warrant:  Warrant with less than 3 months to maturity
Medium term warrant:  Warrants with 3 to 6 months left to maturity
Long term warrant:  Warrants with more than 6 months running to maturity.


Whether it is long-term or short-term, ITM or OTM, a warrant is after all a leveraged investment instrument.
Be cautious in funds allocation and stop-loss arrangements.

Do not get carried away by the potential return without considering your risk tolerance.


For example:

A general investor may consider a medium-term warrant with around 3 months running to maturity and a strike price around 5% above or below the underlying price.

More aggressive investors may go for OTM warrants with a shorter maturity.

For conservative investors, they may choose ITM warrants with a longer maturity.



The warrant price tends to be positively related to the length of maturity.

In theory, the longer the maturity, the more room for changes in the underlying price will be.

Given the greater chance for the warrant to be exercised, the warrant price will tend to be higher.

No matter for call warrants or put warrants, the warrant price tends to be positively related to the length of maturity.

Besides, a warrant expiring in 6 months is less affected by time decay than one expiring in 3 months.

Warrants with a longer maturity will see their time values fall slower, while those with a shorter maturity will see their time values fall faster.

Deep in the money (deep ITM) and far out of the money (far OTM) warrants

If we take into account the extent of difference between the strike price and the underlying price, warrants can be further classified into:

ITM
deep ITM
OTM and
far OTM.

Generally, where there is a 15% or above difference between the strike price and the underlying price, a warrant will be considered far OTM or deep ITM.

However, this 15% mark is merely a rough idea, not an absolute threshold.

One must also look in the volatitlity of the underlying.

Some warrants may be considered deep ITM or far OTM even if the difference between strike price and the underlying price is only 10% or more.

Warrants - In the money, at the money and out of the money

A warrant is described as in-the-money (ITM), at-the-money (ATM) or out-of-the-money (OTM), depending on the relationship between its strike price and its underlying price.

A call warrant is OTM when its strike price is higher than its underlying price.

It is ITM, when its strike price is lower than its underlying price.

The situation is just the opposite for put warrants.

When its strike price is higher than its underlying price, a put warrant is ITM; and when its strike price is lower than its underlying price, it is OTM.

No matter it is a call or put, if the strike price is equal to the underlying price, the warrant is said to be ATM.


Summary

Call Warrant

ITM Strike Price < Underlying Price
ATM  Strike Price = Underlying Price
OTM  Strike Price > Underlying Price

Put Warrant

ITM   Strike Price > Underlying Price
ATM  Strike Price = Underlying Price
OTM  Strike Price < Underlying Price



Additional Notes

Call Warrant
An investor can buy a call warrant if he is optimistic about the outlook for its underlying.
When the underlying price does go above the strike price, in theory, the investor can exercise the warrant to buy the underlying at the strike price.
Then he can sell it in the market to earn the difference.
In practice, warrants are traded on a cash settlement basis, and investors will be paid the difference directly.

Put Warrant
In the case of a put warrant, an investor can go for it when he is pessimistic about the market outlook.
If the underlying price is lower than the strike price, in theory, the invstor can exercise the warrant and buy the underlying from the market for delivery to the issuer at the strike price to earn the difference.
In reality, investors will be paid the difference directly.
If it turns out that the underlying price is higher than the strike price, the investor will lose the cost of the warrant.

(The above assumes that the investor will hold the warrant until maturity.  Indeed, investors can also "buy low, sell high", and trade warrants just like stocks.)

Covered Warrants

Covered Warrants are mainly issued by investment banks.

They are issued to offer a leveraged investment tool for investors.

Cash settlement is the norm for Covered Warrants; thus companies will not face any changes in their shareholding structures as a result.

In other words, Covered Warrants will not dilute a company shareholding.


Unlike Company Warrants, Covered Warrants have good liquidity due to the market making system.

Their pricing mechanism is more transparent (statistics such as effective gearing is readily available).

It is possible to track changes in the theoretical prices of Covered Warrants.

Investors should study the relevant information carefully and bear in mind their own risk tolearance in making the decision whether to invest in Covered Warrants.

Penny Warrants are very risky.

Warrants with only 1 - 2 weeks left to maturity and over 10% out-of-the-money (OTM) are called penny warrants.

They are very risky and their odds are low.  The reasons are as follows:

1.  The bid/ask spreads of penny warrants are rather wide.

2.  Penny warrants have a very high rate of time decay.

3.  It is easy to lose money with penny warrants.

4.  Penny warrants may be not that price sensitive.  

5.  Penny warrants can hardly edge up but easily plummet.