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The Risk of Investing in Warrants

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A warrant is an investment tool which provides opportunity for investors to diversify their investment. It is popular among retail investors, mainly due to its low cost investment and potential high return characteristics.

A warrant is an investment tool which provides opportunity for investors to diversify their investment. It is popular among retail investors, mainly due to its low cost investment and potential high return characteristics. This makes it even accessible to small investors who are without much additional capital.

 

However, many investors are investing into warrant without fully understanding the fundamental mechanics of how warrant works and the risk inherent in it. At the end of this article, you will be able to understand the basics of warrants and its implications on your investment decisions.

 

Types of warrants

A warrant gives you, as the buyer, the right but not the obligation, to buy or sell a specific number of the mother share or underlying shares at a specified price within a specific period. The holder of a warrant or call warrant will not have any voting or dividend rights as that enjoyed by shareholders. One of the main benefits of investing in a warrant is cost leveraging. When you invest in a warrant, you stand to gain from the exposure of the share price movement at only a fraction of its cost.

There are two types of warrants: call warrant and put warrant.

A call warrant is one that is most common in our local stock exchange and is almost similar to an option. A warrant is issued by the company of its underlying stock, while an option is a financial instrument of the stock exchange. Warrants are usually issued by companies as part of new issue offering to attract investors into buying the new security. A warrant is also considered a type of equity derivative as it derives its value from its underlying security.

 

Exercise price (strike price)

The price at which you can buy call warrant is called the exercise price and this is determined at point of issue. The exercise price is the point of reference for you to determine whether your warrant is Out-of-the-Money (OTM), In-the-Money (ITM) or At-the-Money (ATM).

Gearing effect

One of the reasons why warrant attracts investors is mainly because it costs only a fraction of the price of the underlying stock while offering relatively good return, either positive or negative.

 

Let’s take an example of ABC shares that are currently priced on the market at RM2.00 per share. Investor A puts in RM2,000 to purchase 1,000 shares. Investor B on the other hand, decides to invest the same capital of RM2,000 in warrants that was going for RM0.50 per warrant. With the same amount of investment, Investor B is in possession of 4,000 shares.

 

If ABC gains RM0.30 per share from RM2.00, to close at RM2.30, the percentage gain would be 15%. However, with a RM0.30 gain in the warrant, from RM0.50 to RM0.80, the percentage gain would be 60%.

This is the leveraging effect of warrant. However, the possibility of huge gain also comes hand in hand with huge loss. During the life time of a warrant, it is also common that the price of warrant moves in parallel with the price of the underlying stock. Due to the leveraging effect, a small decline in the price of the underlying stock will result in a significant drop in the price of its warrant.

 

Using the example above, assuming the price of the underlying stock reduce from RM2.00 to RM1.80, the percentage drop is 10%, but, with the same amount of RM0.30 reduction in the warrant, it will cause the warrant to drop to RM0.20, which is a 60% drop in value.


 

Time to maturity

All warrants have a limited life span. In the event that the price of the underlying stock remains below the exercise price at the time the warrant matures, an OTM warrant will be of no value and the investor will lose his investment.

Risk control

Having such a high risk nature, investors who are interested in warrants must fully understand their own risk tolerance level. Too much exposure in warrant may subject their investment portfolio to excessive risk. Many investors tend to purchase warrants that are highly active in the market without much knowledge of what they are buying. As warrants are also popular among short-term speculators, an actively traded warrant may not be suitable for investors who intend to hold the warrant for a longer term. The amount could be provided by short-term traders who are speculating and attempting to earn short-term profit. Therefore, it is important for investors to pay attention to the type of market participants that are interested in the warrant.

 

Buying ITM warrants may offer less profit but lower risk compared to the OTM warrants. When a warrant is deeply OTM, it is less sensitive to the price movement of its underlying stock, which means even if the price of the stock increases, the price of its warrant may not have significant movement, as what we would expect out of a warrant that is near or in-the-money. Worst still, if the term of warrant is near to its maturity; its time value will decline drastically.

 

As in any other investment, investors should make sure that they fully understand the characteristics of warrant before they decide to invest in any of it.

© Securities Commission Malaysia (SC). Considerable care has been taken to ensure that the information contained here is accurate at the date of publication. However no representation or warranty, express or implied, is made to its accuracy or completeness. The SC therefore accepts no liability for any loss arising, whether direct or indirect, caused by the use of any part of the information provided. The information provided is for educational purposes only and should not be regarded as an offer or a solicitation of an offer for investment or used as a substitute for legal or other professional advice. For enquiries regarding sharing, republishing or redistributing this content please write to: [email protected].

What Are Structured Warrants?

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Are you aware that you can invest in warrants as an alternative to shares? What is a warrant? Is it risky? Read on to find out more.

Are you aware that you can invest in warrants as an alternative to shares? What is a warrant? Is it risky? Read on to find out more.

Essentially, when you invest in a warrant, you are making a "reservation" to buy a predetermined number of shares at a certain price in the future. A warrant is a derivative, which means that its value is derived from the underlying shares. It provides a cheap way of investing in a listed company's shares without having to pay the full amount. The downside is that it has a maturity period - usually up to 10 years - and is worthless if an investor holds it beyond the maturity date. It also does not give warrant holders any voting right, dividend and right to claim against the company's assets.

IQ Bijak Labur Glossary

  • Underlying Shares:
    Also known as the "mother share", which the warrant is based on.
  • Exercise Ratio:
    Number of shares that a warrant will convert into if the warrant is exercised.
  • Exercise Price:
    The agreed price for a warrant holder to buy shares based on the exercise ratio if a warrant is exercised.
  • Expiry Date:
    The last day on which the warrant may be exercised. The expiry date of each warrant will be defined by the issuer of the warrant.
  • Settlement:
    What a warrant holder receives when he exercises the warrant. It could be either cash or physically settled.

When a warrant holder wants to "exercise" and the exercise price (inclusive of the cost of the warrant) is less than the market price of the underlying share, the warrant holder will make a profit. However, if the exercise price is higher, the warrant holder will lose money. Examples of warrants are Khazanah's basket warrrants, CIMB's basket warrants, single stock warrants and OSK's zero strike call warrants.

*To learn more about warrants, go here

What is a structured warrant?
To understand what a structured warrant really is, let's compare the characteristics of a company warrant and a structured warrant.

 
Company warrants
Structured warrants

Issued by

Listed company

Third-party financial institution

Underlying shares

Shares of the company

Any company shares that are not related to the financial institution (but must meet the requirements under the SC's Guidelines for the Issue of Structured Warrants )

On exercise

Company will issue additional shares to meet obligations. This results in share dilution

Does not result in dilution of the underlying shares

Maturity period

Up to 10 years

6 months to 5 years

Settlement

The terms and conditions of warrants are freely defined by the issuer

 


 

What to look out for before investing in structured warrants

Action 1 - Understand the characteristics of warrants
As for other investment products, you should get a clear view and gain a better understanding of the nature of warrants, i.e. how it works, its benefits, as well as the risks involved. This is to ensure that warrants are the right investment product that matches your investment goals.

Action 2 - Identify the market direction
A warrant is a derivative product and its value is directly linked to the price of the underlying shares. If the price of the shares goes up (or down), the price of the warrants will move in tandem. For instance, if an investor anticipates that the market will do well, he can buy a call warrant to take advantage of price increases in the future. In the case of cash-settled warrant, if the current price of the underlying share is higher than the warrant's exercise price and the warrant is exercised (before the maturity period), the holder will be entitled to the cash amount, i.e. the positive difference between the current price of the share and the warrant's exercise price.

Action 3 - Determine the investment horizon
Set a deadline for the underlying share to reach its target level. Remember that structured warrants are a short-term trading instrument and will expire after the exercise period.

Action 4 - Comparing warrants
When you have narrowed down your choices to two to three warrants, you need to compare the warrant prices by identifying how the price of the underlying share fluctuates during a specific period of time. As a general rule, a warrant with a stable price fluctuation is a better choice for investment.

Settlement of Structured Warrants

Settlement Methods

* For all cash-settled warrants, the issuer must provide for automatic settlement at expiry date, which means the holder need not to serve a notice of exercise, unlike non-automatic exercise which require the holder to give an exercise notice to exercise the warrants.

 


 

Sample of cash-settled call warrants

Risks in trading structured warrants

Market risk
The market value of a warrant is susceptible to events that affect its demand and supply. If the price of the underlying shares falls below the exercise price at the maturity date of the warrants, then the warrant holders will sustain losses in their investments. For illustration, a call warrant carries an exercise price of RM20 and it costs RM1.50 per warrant. Each warrant enables the holder to purchase the warrant at exercise price. Given the market price of the stock at the end of maturity is RM15, a holder of one warrant will have to bear a RM1.50 investment loss.

The formula for calculating:
Exercise price of stock (RM20) + Cost of warrant (RM1.50) = RM21.50 (Full settlement price)
Market price of stock at maturity date of warrant = RM15

Credit risk
Credit risk is the risk that the warrant issuer will not be able to fulfil its obligations (i.e. to access the credit rating of the warrant or the performance guarantee of its holding company) on the exercise of the warrant. To prevent this risk, investors must take the initiative to assess the credit risk associated with the warrant issuer.

Limited life of warrants
Warrants have expiry dates and as time passes, the time value of warrants decreases. Assuming all other things being equal, the more time there is left before expiry, the greater the chance that the warrant will become profitable through a favourable move in the future. When a warrant is about to expire, it has no time value. Warrants may expire before an investor's expectation is realised, making them worthless. The maturity period of the warrant is fixed and cannot be extended. Hence, investors must select a warrant that has sufficient time to match their expectations.

Conclusion
As a smart investor, you need to pay attention to the investment product's characteristics and benefits and most importantly, risks before investing. At the end of the day, the same applies to structured warrants.

© Securities Commission Malaysia (SC). Considerable care has been taken to ensure that the information contained here is accurate at the date of publication. However no representation or warranty, express or implied, is made to its accuracy or completeness. The SC therefore accepts no liability for any loss arising, whether direct or indirect, caused by the use of any part of the information provided. The information provided is for educational purposes only and should not be regarded as an offer or a solicitation of an offer for investment or used as a substitute for legal or other professional advice. For enquiries regarding sharing, republishing or redistributing this content please write to: [email protected].

The ABCs of Warrants

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THE ABCs OF WARRANTS

THE ABCs OF WARRANTS


When discussing investments, Malaysian investors typically link it with stock investing and unit trusts. However, relatively little is said about warrants. One of the many possible reasons that warrants take a back seat to stocks is the lack of understanding among investors.

You may have been told that investing in warrants is risky; that they are more volatile compared to stocks. However, if you spend some time to learn about them, you will discover that warrants are in fact a good alternative investment vehicle for you to consider. You can make it a part of your investment portfolio and allow yourself room for diversity if you understand it well enough.  

An article called “The ABC of Warrants” may seem elementary to some, but it always pays to get your foundation right!


What is a Warrant or Call Warrant?

A warrant or call warrant basically gives the holder the right, but not the obligation to purchase a specific number of the mother or underlying shares at a specific price within a specific period. They are often included in a new debt issue as a "sweetener" to entice investors.  The holder of a warrant or call warrant will not have any voting or dividend rights as that enjoyed by shareholders. As such, you need to be mindful of the fact that as a holder of warrants or call warrants, you will not be entitled to have a say in the company’s management decisions.

Warrant vs Call Warrant

The typical difference between a warrant and a call warrant is that a warrant is issued by a company for the purpose of raising capital for that company. Warrants are usually tagged with a longer maturity, usually more than 4 years stretching up to 10 years. A call warrant on the other hand is issued by third party financial institutions on shares of an unrelated company or shares of a basket of companies. Call warrants usually come with a much shorter maturity period (less than one year).

American or European?

Warrants and call warrants can also be subdivided into two categories based on their exercise style – either American or European. An American warrant can be exercised at any time up to its maturity date while a European warrant can only be exercised at its maturity date. What happens when an investor exercises his rights for a company’s warrant is that the company will issue new shares to meet its obligations, which will result in share dilution. As for a call warrant, the issuer will meet its obligation using outstanding shares. Hence, no new shares will be issued under the call warrant. If the warrants or call warrants are not exercised on expiration, they will be rendered worthless.

Value of Warrants and Call Warrants

The value of a warrant is determined by two main factors, its intrinsic value and time value. Its intrinsic value is the difference between the current price of the underlying asset and the warrant's exercise price. A warrant has a limited life span and as such, in terms of time value, as time passes the value will decrease accordingly until it turns zero on expiration. The factors that will positively affect a warrant's time value are the expected volatility of the underlying stock and the warrant's time to maturity.

Why invest in warrants?

The main benefit of investing in a warrant is cost leveraging. When you invest in a warrant, you stand to gain from the exposure of the share price movement at only a fraction of its cost. In terms of percentage, a warrant is more sensitive to the market movement compared to its underlying assets. Therefore, by investing in a warrant, it allows you to benefit from unlimited upside at a lower cost. Apart from that, you can free up your capital to invest in other investments. The downside risk of not being able to exercise the warrant is only the loss of the warrant premium.


What should you do?

If you want to invest in warrants, you should first understand how the product works and the risks associated with them. The performance of a warrant is closely linked to the price movement of its underlying assets. As such, if you are expecting an uptrend market and have strong confidence in the underlying shares, then the chances of you reaping rewards from investing in warrants is very high. However, if the market is experiencing a downward trend and the time to maturity of your warrants is limited, then you should be more cautious in buying them. This is particularly crucial if the current market price of the underlying share is lower than the exercise price of the warrant. A more disciplined way of investing in warrants is to set a time limit for the underlying share to reach your targeted price. If the price does not measure up to your expectations by then, you will need to re-evaluate your position according to your risk/return profile.

In instances where the stock market has been bearish and you have no idea whether the market trend is going to reverse anytime soon, you may want to go for warrants with a longer time to maturity. A warrant based on an underlying stock that is in good financial health with good business prospects and has at least 3 years to maturity can be an option for you.


SECURITIES COMMISSION MALAYSIA (SC), the leading capital markets education, training and information resource provider in ASEAN, is the training and development arm of the Securities Commission, Malaysia. It was established in 1994 and incorporated in 2007.

For more tips on wise investing, log on to www.investsmartsc.my  
 

© Securities Commission Malaysia (SC). Considerable care has been taken to ensure that the information contained here is accurate at the date of publication. However no representation or warranty, express or implied, is made to its accuracy or completeness. The SC therefore accepts no liability for any loss arising, whether direct or indirect, caused by the use of any part of the information provided. The information provided is for educational purposes only and should not be regarded as an offer or a solicitation of an offer for investment or used as a substitute for legal or other professional advice. For enquiries regarding sharing, republishing or redistributing this content please write to: [email protected].