Advice: Be extra careful when buying into warrants near maturity

Good Piece of Information from TheStar :-

LATELY, as a result of better stock-market sentiment, investors are starting to pay attention to warrants. With their prices relatively lower than that of mother shares, warrants are viewed as an alternative to achieving higher returns and providing cheaper entry to the mother shares.

What is a warrant?

A warrant is a transferrable option certificate issued by a company that entitles the holder to buy a specific number of shares in that company at a specific price (or exercise price) at a specified time in the future.

Normally, a company issues warrants together with bonds to raise capital. Because investors can detach the warrants and sell them separately to get some returns, the coupon rates for these bonds will be lower.

As a result, we can treat this as a “sweetener” for investors to attract them to buy into lower coupon-rate bonds. Besides, capital raising through warrants will be less disruptive to a company’s earnings as investors are given a certain period to exercise their rights.

The intrinsic value of a warrant is the value that an investor will get if the warrant were to be exercised immediately. It is the difference between the price of the mother share and the exercise price.

A positive intrinsic value means the warrant is “in-the-money” and the investor may exercise his rights now given that he can buy the mother share at a cheaper price. A negative intrinsic value means the warrant is “out-of-money” and the investor will not exercise his rights as he has to pay higher than the current market price for the mother share.

Usually, warrants are traded at a premium because investors are willing to pay extra for the benefits that warrants offer. However, investors need to know the premium that they are paying. Premium can be computed based on the following formula:

PREMIUM (%) = (WARRANT + EXERCISE PRICE – SHARE PRICE)/SHARE PRICE X 100

For example, if Company A’s share price is RM4.50 and the exercise price is RM3.75, Company A’s warrant (Company A-W) price of RM1.36 will imply a premium of 13.6%.

Premium = (1.36 + 3.75 – 4.50)/4.50 x 100 = 13.6%.

For any given warrant, the higher the premium, the more expensive the warrant becomes. If an investor pays a premium to buy a warrant, the underlying share must rise by a percentage equal to the premium before the maturity date to break even.

The main reason for the preference shown by investors in buying warrants instead of their mother shares is the gearing factor. It is computed by dividing the mother share price by warrant price.

Based on the above example, the gearing factor for Company A-W is 3.31 times (4.50/1.36). It means that by buying into Company A-W instead of Company A (with the same amount of investment), the exposure to Company A is 3.31 times larger than investing in Company A (the mother share) itself.

Hence, due to the lower price relative to the price of the mother share, gearing can show how many times a warrant is able to outperform or under-perform versus the mother share.

Capital Fulcrum Point (CFP)

CFP combines premium and time-to-maturity to provide a compound indicator. It can be interpreted as the average percentage increase in the price of the mother share per year assuming all other factors remain constant.

It is computed based on the following formula:

CFP = [{EXERCISE PRICE/(SHARE PRICE – WARRANT PRICE)} ^ (1/Y) – 1] X 100

Where y = the remaining years-to-maturity, ^ means to the power of

Based on the above example, if y = 5.82 years, CFP for Company A-W = [{3.75/(4.50 – 1.36)} ^ (1/5.82) – 1] x 100 = 3.1%.

It means that if Company A is able to grow by at least 3.1% a year, it will be cheaper to buy Company A-W than investing in Company A’s mother share.

In short, we can consider this CFP as taking the premium divided by the remaining time-to-maturity. When we take the above 13.6% premium and divide by 5.82 years, we will get 2.34%. Even though we cannot get the actual CFP, 2.34% can provide us with a close approximation to the correct CFP of 3.10%.

Due to the gearing factor, even though investors can get higher returns by investing in warrants instead of buying the mother shares, we need to understand the risks involved. Investors need to be extra careful when buying into warrants, especially those that are near their maturity.

Investors need to exercise the warrants or sell them into the market before the maturity dates because the warrants will become worthless after those dates.