Warrant Fundamentals

From

Financial planners do not typically provide much advice on direct derivative strategies, wisely leaving this type of activity to specialists within stock-broking firms. Some clients, however, may benefit from the prudent use of warrants within their self-managed superannuation funds, and the obligation to keep competencies up to date applies to all areas in which an adviser is authorised to provide advice. Consequently, this extract from Pinnacle’s Derivatives Course provides a review of the fundamentals of warrants, for those who are authorised in derivatives but do not practice in the area, or for those advising on SMSF who need a refresher. Note that this article is restricted to a general review of warrants. We will review the benefits and risks of the use of warrants within SMSF in a future issue later in the year.

Distinction between Warrants and Options

Option contracts are standardised, but there is a wide range of warrant types. Offerings from the different issuers vary significantly, and each warrant has its own distinct terms and conditions. The issuers of warrants must produce a disclosure document (PDS) for each warrant it offers. It is essential for investors to read and fully understand these documents before investing. Of course it is equally important for an adviser to do the same before advising a client to acquire any particular security, to satisfy the “know your product” requirement.

Warrants may be either call warrants, where the holder has the right to buy an asset at a predetermined price by or at a predetermined date, or put warrants where the holder has the right to sell an asset. Unlike options, investors are unable to write (short sell) warrants.

Underlying Assets

Warrants are issued over a variety of underlying assets. These include:

  • individual shares
  • baskets of shares
  • share market indices
  • commodities
  • currencies

Trading and Investment Warrants

Warrants are generally classified as either “trading warrants”, designed for investors with shorter term investment horizons, or “investment warrants” for investors looking to gain longer term exposure to an underlying asset. Trading warrants tend to be higher risk/return than investment warrants. The distinction between the two categories is not always clear-cut, and some warrants may have features of both types.

Trading warrants include:

  • equity put and call warrants
  • equity barrier warrants
  • currency warrants
  • index warrants
  • commodity warrants

Investment warrants include:

  • instalments
  • capped warrants
  • basket warrants
  • endowments
  • structured investment products (ALPS, YIELDS)
  • premium income warrants (PIES)

The diversity of structures, underlying assets and payoff profiles is one of the features of warrants that make them attractive to investors. However, as a result of this diversity they also present a fairly complex mix of risk/return profiles and strengths and weaknesses. Whether a particular warrant instrument is appropriate for a particular investor will depend upon the structure and terms of the instrument and the profile and investment goals of the investor.

Warrant Terms and Pricing Variables

Unlike options, warrants do not have standardised contract terms. However, depending on the type of warrant, the warrant price is influenced by many of the factors that affect option premiums, including:

  • spot price of the underlying instrument
  • strike price
  • volatility of the underlying investment
  • interest rates
  • dividends

These variables may have different effects on different warrant types. For example, some warrants, such as instalments, entitle the holder to the dividends paid on the underlying investment. A dividend payment will therefore affect an instalment differently from a trading warrant, where the holder is not entitled to the dividend.

Other Warrant Variables

While the variables listed above are common to both options and warrants, there are a number of others that may be unique to warrants. These include:

  • settlement terms—warrants may be deliverable by transfer of the underlying instrument or they may be cash settled
  • conversion ratio—the number of warrants that must be exercised to enable delivery of one unit of the underlying instrument. All else being equal, the higher the conversion ratio, the lower the warrant price. To calculate the warrant price on a per share basis, multiply the price by the conversion ratio. For example, a warrant with a conversion ratio of 4:1, that is trading at $0.10, is worth $0.40 on a per share basis
  • covering—a covered warrant is one offered by an issuer who holds the underlying instrument in a legal structure on behalf of the holder. The existence of physical cover reduces the counterparty risk faced by the investor
  • index multiplier—this is applied in the case of index warrants to determine the amount to be paid to the investor at expiry
  • cap levels—this refers to the upside cap placed on some warrant series that limit the investor’s return. Essentially, this represents an option written back to the issuer by the investor that is embedded in the structure. All else being equal, a capped warrant will trade at a lower price than an uncapped warrant
  • barrier levels—these are defined levels, the breach of which causes some event to occur. Some barriers may cause a warrant to terminate before the original expiry date while others may cause an adjustment to the exercise price
  • assessed value payment (AVP)—unlike options where the failure to exercise an in-the-money option at expiry results in the complete loss of the option’s value, the warrant issuer will make a payment to the holder if an in-the-money warrant expires unexercised. If the warrant is deliverable, the issuer must pay the holder an AVP, which is the warrant’s intrinsic value less reasonable costs. If the warrant is cash-settled, 100 percent of the intrinsic value must be paid to the holder.

Advantages and Disadvantages

Advantages of using warrants include:

  • convenient gearing—there is no need to arrange a credit facility
  • a wide variety of instruments to meet a range of both speculative and longer term investment objectives
  • depending on the terms set out by the issuer, a holder of a warrant may be entitled to receive dividends and franking credits
  • the ability to extract cash from physical share portfolios by transferring them into instalment warrant instruments
  • innovative structures that allow the targeting of high-income yields
  • tradeable on ASX
  • ASX oversight of market
  • tax benefits, depending upon the type of warrant and the investor’s individual circumstances
  • time to decide for the buyer of the warrant, until expiry, whether or not to take delivery of the underlying securities (or if cash settled, await expiry)

Disadvantages and risks of using warrants include:

  • the diversity of non-standardised structures can make it difficult for investors to compare offerings over the same underlying assets
  • some warrant structures are quite complicated and require a high level of investment sophistication to fully understand the payoffs and costs
  • the absence of a central counterparty means that investors face higher credit risk than with other exchange-traded instruments
  • depending upon the popularity of particular issues, liquidity may be quite low
  • the inability of investors to write warrants may inhibit the arbitrage mechanism that generally acts to ensure fair pricing in derivatives markets
  • warrants entail significant costs for issuers, including the maintenance of an investor register, client services function, regular issue of new instruments, provision of finance, compliance with ASX Market Rules and managing and hedging their market exposures. These costs must be passed on to investors and may make them expensive when compared to other structures
  • limited life of warrants may mean that the expected price movement does not occur before expiry

Warrants versus Options

While options and warrants share many characteristics, there are significant differences. The following table sets out the main differences.

 

Note: The accreditation for this CPD article is no longer current. Please visit our CPD section for current CPD quizzes

 

You must be logged in to post or view comments.