What is Warrants? A brief introduction of investing warrants

Introduction to Warrants

A warrant is a derivative instrument which entitles the holders the right, but not the obligation to buy or sell the underlying security (can be a share, a basket of shares, a share index, a foreign currency or virtually any type of traded security) at a predetermined price known as the Exercise Price or Strike Price on or before a pre-determined date known as the Expiry Date.

Warrants can be classified as American Style, European Style or Bermuda Style. An American Style warrants can be exercised any time during the life of the life of the warrants, while European Style warrants can only be exercised on the expiration date. The Bermuda Style warrants can be exercised during certain periods during the life of the warrants. Most of the company issued warrants listed are American Style warrant while covered or structured warrants listed in Bursa Malaysia are European Style warrants.

Warrants do not pay dividends or come with voting rights. Investors are attracted to warrants as a means of leveraging their positions in a security, hedging against downside (for example, by combining a put warrant with a long position in the underlying stock) or exploiting arbitrage opportunities. Warrants are no longer very common in the U.S., but are heavily traded in Hong Kong, Germany and other countries.

There are two types of warrants that are listed on the stock exchange:

       1    Company Issued Warrant

A Company Warrants are issued by the listed companies themselves.

       

       2     Covered or Structured Warrant (also known as Derivative Warrant)

Covered or Structured Warrant are issued by investment banks or major shareholders of the company. Investment bank may issue warrants on a single stock, or a basket of stocks, indices, commodities etc.

Each warrants listed (company issued warrant or structured warrant) are categorized into call warrant and put warrant.

In a call warrant, the investor pays a price (or premium) for owning it. If at expiry, the price of the underlying share is higher than the exercise price, the investor will exercise the warrant. The different between the market price of the underlying share and the exercise price is the gross profit on the warrant investment. Net profit is arrived after deducting the price paid for the warrant from the gross profit. However, if the price of the underlying share is below the exercise price, the warrant will expire worthless. The loss is limited to the price (premium) paid.

For the put warrant, the situation is the opposite. If the price of the underlying share is below the exercise price on expiry, investor will exercise the put warrant and sell the share at the exercise price, claiming the difference between the market price and the exercise price as the gross profit. If the price of the underlying share is above the exercise, the put warrant would not be exercised.

Company Issued Warrants

Company warrants are issued by companies. These warrants are exercisable into new shares of the underlying company at the exercise price. The purpose of issuing warrant by the company usually as part of a capital raising exercise while a rights issue of warrants can be viewed as a deferred capital raising exercise. However, the issuance of warrants by a company, upon their exercise, will dilute the company’s earnings per share (EPS).

Example:

Bioalpha Holdings Berhad issued 133.3 million company warrants of Biohldg (0179) that can be exercisable into 133.3 million new shares of Bioalpha at an exercise price of RM0.220. The warrants are free detached of the renounceable right issue offered to the shareholders at a subscription price of RM0.200 on the basis of one warrant for every one right issues subscribed.

Instrument Category	Securities of PLC
Instrument Type	Warrants
Description	Issuance of free detachable warrants ("Warrants") pursuant to the renounceable rights issue of 133,333,131 new ordinary shares of RM0.05 each in Bioalpha ("Bioalpha Shares") ("Rights Shares") at an issue price of RM0.20 per Rights Share on the basis of 1 Rights Share for every 5 existing Bioalpha Shares held at 5.00 p.m. on 8 December 2016, together with 133,333,131 Warrants on the basis of 1 Warrant for every 1 Rights Share subscribed.
Listing Date	10 Jan 2017
Issue Date	06 Jan 2017
Issue/ Ask Price	Not Applicable
Issue Size Indicator	Unit
Issue Size in Unit	133,333,131
Maturity	Mandatory
Maturity Date	05 Jan 2022
Revised Maturity Date
Name of Guarantor	Not Applicable
Name of Trustee	Not Applicable
Coupon/Profit/Interest/Payment Rate	Not Applicable
Coupon/Profit/Interest/Payment Frequency	Not Applicable
Redemption	Not Applicable
Exercise/Conversion Period	5.00   Year(s)
Revised Exercise/Conversion Period	Not Applicable
Exercise/Strike/Conversion Price	Malaysian Ringgit (MYR)   0.2200
Revised Exercise/Strike/Conversion Price	Not Applicable
Exercise/Conversion Ratio	1:1
Revised Exercise/Conversion Ratio	Not Applicable
Mode of satisfaction of Exercise/ Conversion price	Cash
Settlement Type/ Convertible into	Physical (Shares)

In the above real case example, Biohldg will issue new shares of the company when the warrants are exercised. The existing share capital is 800.0 million shares after the completion of the right issue exercise, the exercise of 133.3 million warrants into 133.3 million new shares will increase the share capital to 933.3 million. This has the impact of expanding the share capital of the company.

Some investors do not like listed companies to issue warrants or other convertible instruments as they do not like dilution to the earnings per share of the company.

Warrants are typically issued when the company is undertaking a capital raising exercise. It is very common for listed companies to issue warrants together with a rights issue in Malaysia. When the market price of the company is not significantly higher or below the rights issue price of new shares, the free warrants attached to the rights issue serve as a “sweetener” for shareholders to take up the right issue.

Rights Issue of Warrants

Naked rights issues of warrants are also increasingly popular with listed companies. The rationale for such issues of warrants is generally to create value for the shareholders. It also enables the shareholders of the issuing company to enjoy a future upside of the company’s share price at a lower cost since warrants cost only a fraction of the share price. The issue price of these company warrants are generally fixed at a lower price so that shareholders will be profitable from subscribing the warrants.

Example:

Gamuda Bhd proposed a right issue of warrants at on RM0.250 on 9 November 2015 when its share price was closed at RM4.59. This new issue of Gamuda warrants were offered that it was very likely that the shareholders would be making handsome gains over the offer price when the warrant got listed (Closing on 3 March 2017: RM1.18, a 372% gain if shareholders still holding until now. If the shareholders sell at the peak (approximately RM1.40), they would have made a profit of 460% in one year).

The only little problem with this issue was that shareholders only entitled to only one warrant for every six shares held.

Instrument Category	Securities of PLC
Instrument Type	Warrants
Description	WARRANTS IN GAMUDA BERHAD ("GAMUDA") ("WARRANT(S)") ISSUED PURSUANT TO THE RENOUNCEABLE RIGHTS ISSUE OF 400,984,509 WARRANTS ON THE BASIS OF ONE (1) WARRANT FOR EVERY SIX (6) EXISTING ORDINARY SHARES OF RM1.00 EACH HELD IN GAMUDA AT 5.00 P.M. ON THURSDAY, 11 FEBRUARY 2016, AT AN ISSUE PRICE OF RM0.25 PER WARRANT ("RIGHTS ISSUE OF WARRANTS")
Listing Date	11 Mar 2016
Issue Date	07 Mar 2016
Issue/ Ask Price	Malaysian Ringgit (MYR)   0.2500
Issue Size Indicator	Unit
Issue Size in Unit	400,984,509
Maturity	Mandatory
Maturity Date	06 Mar 2021
Revised Maturity Date
Name of Guarantor	Not Applicable
Name of Trustee	Not Applicable
Coupon/Profit/Interest/Payment Rate	Not Applicable
Coupon/Profit/Interest/Payment Frequency	Not Applicable
Redemption	Not Applicable
Exercise/Conversion Period	5.00   Year(s)
Revised Exercise/Conversion Period	Not Applicable
Exercise/Strike/Conversion Price	Malaysian Ringgit (MYR)   4.0500
Revised Exercise/Strike/Conversion Price	Not Applicable
Exercise/Conversion Ratio	1 : 1
Revised Exercise/Conversion Ratio	Not Applicable
Mode of satisfaction of Exercise/ Conversion price	Cash
Settlement Type/ Convertible into	Physical (Shares)

In Malaysia, listed company warrants have a maximum lifespan of ten years. The warrant deed poll must also not contain a provision for extension of exercise period after the Securities Commission disallowed warrants to be extended in 2011. Up to date, all company warrants listed in Malaysia are call warrants.

Covered or Structured Warrant

Structured warrants are issued by third parties other than the underlying company. The third parties involved are usually investment banks or stock brokers that run derivatives business. It is also possible that major shareholders of the company to issue covered warrants. However, in Malaysia, only investment banks and stock brokers that issue covered warrants.

Investment banks issue structured warrants as a business, they are expected to “create a market” for the warrants by providing the bid and ask prices for the warrants. The most popular structured warrants listed in Malaysia are call warrants. While first put warrants introduced to Bursa Malaysia was in 2014.

Besides call warrants and put warrants, investment banks also introduced more exotic structured products under the structured warrants platform of the stock exchanges. Some examples include Range-Accrual Notes, Discount Certificates (or Bull Equity-Linked Structures), installment warrants, etc. Nevertheless, such products have not been as popular as the more straight forward call and put warrants.

Unlike company warrants, structured warrants are usually cash-settled. This means that investors do not need to come up with cash to exercise the warrants. In such cases, the issuers will pay the warrant holders the different between the share price and exercise price adjusted by exercise ratio and foreign exchange (if any).

Factors affecting the price of warrants:

The price of warrant is determined by the factors as follow:

• 1         The price of the mother share (or underlying security)
• 2.       Exercise price
• 3.       Time to expiry
• 4.       Share price volatility
• 5.       Interest rate
• 6.       Dividend rate

When the following increases…	Impact on Call Warrants Price	Impact on Put Warrants Price
Share price	↑	↓
Exercise price	↓	↑
Time to expiry (getting neared to expiry)	↓	↓
Share price volatility	↑	↑
Interest rate	↑	↓
Dividend rate	↓	↑

* Details of factor affecting the price of warrants will be discuss in future article.

Basic Indicators:

When investing in warrants, it is important for investors to understand the terms and indicators to gauge the attractiveness of the warrants.

     

     1.Intrinsic Value:

Intrinsic Value = Share Price – Exercise Price

Warrant s allows their holder to buy share at an exercise price. If the share price is higher than the exercise price, the warrant is said to be in-the-money. While if the share price is less than the exercise price, the warrants is said to be out-of-money.

                Call warrants:

                                In-the-money: Share price > Exercise Price

                                At-the-money: Share price = Exercise Price

                                Out-of-money: Share price < Exercise Price

                Put warrants:

                                In-the-money: Share price < Exercise Price

                                At-the-money: Share price = Exercise Price

                                Out-of-money: Share price > Exercise Price

When a warrant is in-the-money or has intrinsic value, it is worthwhile to exercise the warrant as the exercise price is lower (higher for put warrant) than the share price.

When a warrant is at-the-money, it means that the share price and exercise price are about the same and it makes no difference whether to buy the share from the market or exercise warrant. Since exercising the warrant would take time, at-the-money warrant is usually not exercised unless there is a strategic reason behind the exercise.

When the share price is less than the exercise price (more than the exercise price for put warrants), the warrant is said to be out-of-money. Warrant holders are not expected to exercise out-of-money warrants because the underlying share can be bought (sold for put warrants) from the market at lower price (higher price for put warrants).

      2    Parity Ratio:

Parity Ratio = Share Price / Exercise Price

A call warrant with a parity ratio of over 1.0 will be in-the-money, below 1.0 is out-of-money, and equal to 1.0 is trading at parity.

A put warrant with a parity ratio of below 1.0 will be in-the-money, above 1.0 is out-of-money, and equal to 1.0 is trading at parity.

      3    Premium:

Call warrants:

        Premium

= { (Warrant Price * Conversion Ratio) + Exercise Price – Underlying Price } / Underlying Price * 100%

Example (Bioalpha Holdings Berhad – Based on closing price on 3 March 2017):

Mother’s Share Price	RM0.265
Warrant’s Price	RM0.185
Exercise Price	RM0.220
Conversion Ratio	1:1
Conversion Date	5 Jan 2022

Premium = { (0.185 * 1) + 0.220 – 0.265} / 0.265 * 100% = 52.8%

Put warrant:

Premium

= { (Warrant Price * Conversion Ratio) + Underlying Price - Exercise Price} / Underlying Price * 100%

Example (FBMKLCI Index – Based on closing price on 3 March 2017):

Index Point	1708.38
Warrant’s Price (FBMKLCI-H2T)	RM0.070
Exercise Point	1670.00
Conversion Ratio	700:1
Conversion Date	29 Sept 2017

Premium = { (0.070 * 700) + 1708.38 – 1670} / 1708.38 * 100% = 5.1%

Premium measures how much more (in percentage terms) an investors is willing to pay for excess of the market value of the underlying security in order to gain an opportunity to enjoy a greater return by buying the warrant.

A warrant with a lower premium is generally preferred to a higher premium warrant because the break-even point is lower. This is especially relevant when the warrant is intended to be held until maturity. However, premium may not be the best indicator to use when trading warrants in the short term.

      4    Gearing:

Gearing = underlying security price / Warrant Price

Gearing measures how many times (units) of warrants one can purchase with an investment in the underlying security or mother share. It is a ratio of mother share price over warrant price.

From the previous example for Biohldg-WA:

                Gearing = 0.265 / 0.185 = 1.43

Biohldg-WA was trading at a gearing of 1.43 times. As a warrant is a leveraged instrument, a warrant with a high gearing ratio tends to move in greater percentage magnitude than the underlying share. Investors hoping to maximize their return on an anticipated rise in share price may want to select the warrants with the higher gearing.

     

      5         Capital Fulcrum Point (CFP):

CFP is the annual compounded percentage growth rate required from the underlying share price for the investor to do equally well on their investment in the associated warrant on expiry. It is usually used for longer term call warrants.

For the above example with Biohldg-WA where the expiry is 4.83 years to expiry on date of reference:

               

This means that an investor who bought Biohldg-WA at RM0.185 would enjoy a greater percentage return than if he had purchased the mother share, provided Biohldg share price appreciates more than 23.28% for the next 4.83 years. The CFP calculation assumes that Biohldg do not pay any dividend.

CFP is useful because it combines a warrant’s time value, parity ratio and expiry in one indicator. Most investors are afraid to buy warrants with a high premium but CFP can help investors identified long term warrants which are attractive despite the seemingly high premium. CFP is best used as a comparative measure.

* Advanced warrant indicators will be discuss in future article.

Source:

      1.       www.warrants.com.my

      2.       http://www.investopedia.com/terms/w/warrant.asp

      3.       www.bursamalaysia.com

      4.       http://www.original.icapital.biz/english/edu_3.asp

Disclaimer: This article is purely reflects own personal views. All information provided here, including recommendations should be treated for informational purposes only. All analysis do not constitute buy or sell recommendations.