What exactly are structured warrants? - Part 2

Basics of Structured Warrants

Back to Basics: Structured warrants are proprietary instruments issued by financial institutions that give holders the right, but not the obligation, to buy or sell the underlying assets (in our series, shares) at a future date for a fixed price. The two basic types of structured warrants are call warrants and put warrants. A call warrant gives the holder the right, but not the obligation, to buy the underlying share for a fixed price known as the exercise (strike) price at a future date. This is a synthetic long (buy) position in the underlying share. A put warrant gives the holder the right, but not the obligation, to sell the underlying share to the warrant issuer for the exercise price. This is a synthetic short (sell) position in the underlying share. Call warrants allow the holder to profit from share price increases. Put warrants allow the holder to profit from share price declines.

The differences between traditional company-issued warrants and structured warrants is best described in the table below:

Company-issued warrants Structured warrants

Issuer Company over its own shares Third party banks or financial institutions

Dilution New shares issued upon exercise No new shares issued

Type Limited to call warrants only All natures : call, put, exotic, spread

Expiry Typically spans over many years Typically spans over 6 months to 1 year

Liquidity Dependent on market forces, typically low or inconsistent Depending on market maker, high

Holders Individuals, institution vested in company Investors, traders

Pricing Subjected to demand & supply Priced by market maker to option models

American or European? These two styles of exercise for warrants deserve some closer scrutiny. An American style warrant allows holders to exercise their warrants at any time up to and including their expiry date. European style warrants allow exercise only on the expiry date. All structured warrants issued and listed on Bursa Securities thus far have been American style call warrants (the reasons why call warrants are issued and traded more often than put warrants will be covered in future sections). This is intriguing. For issuers, European style warrants are simpler due to infrequent exercise – only on expiry. In markets of Europe, Hong Kong, and Singapore, there is a historical precedence of the European style warrants. In actuality, neither style seems to have any significant advantage over the other. For investors, the American style warrant appears more preferable owing to exercise flexibility. In reality, where there is active and efficient market making, the existence of time premium before maturity usually makes it uneconomic to exercise listed American style warrants early. Think about it – the lower premium of the European style warrants will be more valuable than an early exercise right which is rarely taken up. So are the American style warrants pricing in additional premium at placement stage? In this aspect, expect to see an evolution of issuance preference in favour of European style warrants.

Strike it Rich: A call warrant is out-of-the-money when the exercise price is higher than the share price and in-the-money when the exercise price is lower than the share price. It will be worthless if the share price is lower than the exercise price on expiry. However, with upward movements in the share price, the holder can still earn excellent returns trading the warrant prior to the expiry date. This is known as the gearing factor (to be covered in subsequent sections).

Right Cover: The exercise (or conversion) ratio of a structured warrant is important in determining the quantity of warrants needed to exercise to buy or sell one underlying share. In the analysis of any warrant, or comparison of many warrants, check the exercise ratio. If the pricing appears far off, the reason could be an erroneous assumption of exercise ratio. To be objective, ensure consistency by, for instance, restating all prices on a “per warrant” basis.

Let illustrate with an example – two similar warrants (same exercise price, expiry) with different exercise ratios. A 1:1 warrant trades at RM0.50, and the other (2 warrants for 1 share) trades at RM0.30. The latter might appear attractive on an absolute basis, but it is actually carrying a higher premium over the RM0.50 tranche.

Settlement: Structured warrants are typically cash settled. In European style warrants, holders redeem a cash amount equivalent to the amount the warrant expired in-the-money. In the local context (American style), holders redeem a cash amount equal to the difference between the closing price prior to the exercise date and the exercise price. For example, if a Gamuda call warrant had an exercise price of RM5.00, holders will receive RM0.50 if Gamuda shares closes RM5.50 the day prior to the exercise date, assuming a 1:1 exercise ratio. For investors, the importance of knowing the precise exercise ratio plays a part in calculating the cash settlement amount.

In the next issue, we will discuss the various basic parameters (gearing, intrinsic and time values, premium) as well as advantages and disadvantages of using structured warrants to enhance your portfolio.