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Structured warrants – caveat emptor!

selected listed call and put warrants. Price is as at September 24.

COVERED warrants are basically derivatives which are traded in the market and “derive” their values based on the underlying shares that they represent. Typically, warrants are issued by companies in conjunction with some other corporate exercise and this could be in the form of inducement for shareholders to subscribe for either a rights issue exercise or in some cases, they are issued as a “reward” to shareholders in the form of a bonus issue.

Warrants issued by companies can either be issued at no cost or in some cases at a nominal fee. Most of these warrants have a typical five-year lifespan and are exercisable any time (which is referred to as American-style option) on the basis of one new share for every one warrant, and if the underlying share price is below the exercise price, most of these warrants expire as worthless instruments as they are out-of-money warrants. Warrants are said to be in-the-money warrants if the underlying share price is above the exercise price. Due to the limited lifespan, warrants have what is referred to as a time value and this time value is effectively the premium that an investor pays.

Hence, let’s say a stock is trading at RM2.00 and has a covered warrant with an exercise price of RM1.60 and the covered warrant itself is trading at RM0.60 per warrant. From here, it can observe that the warrants are in-the-money as the underlying shares are trading above the exercise price and based on the price of the warrants, an investor’s cost is effectively at RM2.20, i.e. the price of the warrants plus the exercise price. As the underlying shares are trading at RM2.00 per share, the investor is paying a RM0.20 premium, which translates to a premium of 10%. This 10% is also referred to as the time value of the warrants between now and the time of maturity of the said warrants.

In addition to covered warrants, we are also seeing an increasing trend of issuance of structured warrants. These are NOT issued by the company themselves but by investment banks (IBs) which are issuing derivative products based on volatility and marketability of the underlying shares. Structured warrants are only allowed to be issued on companies with a daily average market capitalisation in excess of RM1bil for existing listed companies for the past three months and for newly listed companies, a market capitalisation in excess of RM3bil is required. For structured warrants, they are either call or put warrants. In addition, structured warrants are always exercisable at maturity date or otherwise known as European-style option.

Structured warrants typically differ from covered warrants in the sense that they tend to be short-dated (six months to a year) while at the same time have exercise ratio that can range from as low as two structured warrants to one underlying share to as high as 100 structured warrants for one underlying share.

In addition, although Bursa Malaysia’s guidelines allow for settlement of covered warrants in the form of actual exercise into underlying shares (which must be communicated clearly to holders of structured warrants), most structured warrants are cash settled. Cash settlement means an investor would receive cash proceeds if at the expiry of the structured warrants, the derivatives are in the money.

However, being in the money is not enough as most of the structured warrants are sold by IBs based on market price at the time of issuance, which is typically set at RM0.15 per warrant. However, the actual sale price on the first day of listing for these structured warrants normally depends very much on the market price of the underlying shares on the listing day as well as the role played by the market maker themselves as they are the issuer of the structured warrants. In recent years, structured warrants have taken a life of their own not only in the Malaysian context but also globally as it is a high-risk, high-reward game due to the leveraging effect that structured warrants give investors. The leveraging effect comes from the low issuance price of the warrants but the value is derived from the market price of the underlying shares which is much more expensive and typically out of the reach of retail investors.

In the United States, according to Options Clearing Corp (OCC), up to August this year, stock options trading volume is up nearly 46% y-o-y, based on trading activity across 16 exchanges. Last month saw trades jumped 30.4% to 612 million contracts. Some of the drivers of option trading include zero-commission trading platforms like Robinhood and E-Trade have helped make the options market more accessible to investors, even those with little or no experience. Increased market volatility, which favours short-term investing, has made options trading potentially more lucrative.

In a global environment where interest rates are at record low and market sentiment remains positive driven by liquidity factors, the narrow-based rally, especially on those concentrated within the healthcare and technology stocks, have added further fuel to the fire on structured products like call and put warrants – which indirectly is a cheap entry point to the market’s ongoing themes. It is not just retail investors who are attracted to these trades but even some large institutions, but perhaps not in Malaysia as fund managers typically do not trade structured products like call and put warrants. However, it was recently reported that the Softbank Group had bought options worth billions on technology stocks, effectively taking a large bet that the share prices of these companies will continue to rise.

How does one price call or put warrants?

To illustrate actual valuation of call or put warrants, let’s take as an example glove stocks, where these instruments are widely being discussed due to the market volatility. Four different instruments have been picked for analysis to illustrate the mechanics and valuation of call and put warrants of both Top Glove Corp and Supermax Corp.

To ensure it is reflective of the underlying shares, the example is on the most active call and put warrants of the two companies currently. Both Top Glove and Supermax underlying shares underwent a corporate exercise recently with the completion of their respective bonus issues.

Hence, the exercise prices and conversion ratios for all four warrants were adjusted based on the bonus issue ratios.

Based on the statistics on the table, the premium investors are paying on the four structured warrants range from as low as 2.5% for Top Glove C-81 to as high as 105% for Supermax-C1I which expires in July 2021. Looking at the break-even prices of the two call warrants, the likelihood that holders of Top Glove C-81 will obtain some sort of cash settlement on expiry is rather high as the current share price is well above the exercise price while that for Supermax-C1I is well out-of-the-money as the exercise price of RM14.00 per share against the current market price of the underlying shares at RM8.41.

Holders of put warrants on the other hand will make money if the exercise price is lower than the underlying shares and based on current put warrant prices, the premium is at about 28% and 31% for Top Glove-HB and Supermax-HC. Nevertheless, the implied intrinsic value of the put warrant is rather low compared with current put warrant prices and hence, the likelihood that they may expire with investors losing money is rather high. Based on the current put prices, the put warrants are pricing the underlying shares of Top Glove and Supermax at just RM6.16 and RM5.78 respectively.

On the other end of the spectrum of call and put warrants are the IBs. There have been some accusations that they are driving the underlying shares of these companies due to the exposure that these IBs have on the structured warrants.

In the recent issuance of Top Glove-C94, the call warrant has an exercise price of RM10.00 per share and the call warrants has an exercise ratio of 10 Top Glove-C94 for one underlying shares. Over the past five days since issuance, some 31.6 million warrants worth RM3.96mil were traded and the IB issuing the call warrants could have been the main market maker and probably would have sold at least one-third or half of the volume that was traded on the warrants.

Assuming that the issuing IB sold half of it or 15 million warrants at a weighted average price of RM0.125, the bank would have collected proceeds of RM1.875mil from the sale of these new warrants. Now, based on the exercise price of RM10.00, the IB would not need to pay a single sen at maturity unless and until the share price appreciates above the exercise price. For the IB, having collected RM1.875mil in proceeds its break-even point for exercise of the 15 million warrants that are sold is actually at RM11.25 based on the exercise ratio of 10 Top Glove-C94 for one underlying share.

Based on the current consensus target price of Top Glove of RM11.18 and assuming this target price is achieved at the time of maturity of Top Glove-C94 on March 31,2021, the IB would have to fork out RM1.77mil for the cash settlement amount. This would see the IB actually realising a net gain of about RM105,000.

However, as the IB has a mandated size to issue up to 100 million call warrants, it would be natural that up to 100 million call warrants could potentially be sold out by the IB. Let’s assume that Top Glove’s underlying share rises to RM15.00, leaving everything else unchanged, Top Glove-C94 would have probably risen to RM0.50 per warrant just on the assumption that it trades with zero premium or discount. Naturally, the demand for the warrants will rise and the IB would be happily providing the much needed liquidity as investors’ demand would push the warrants price higher and higher, based on the underlying share price.

In this instance, let’s assume that the IB on average sold the Top Glove-C94 at an average price of RM0.30 per warrant. It would have collected some RM30mil in proceeds. If the market price remains at RM15.00 at maturity and the exercise price of the covered warrant is at RM10.00, the IB would have to fork out some RM50mil in total cash outlay to Top Glove-C94 holders upon maturity. Unless, it has hedge itself, the IB would be at loss to the tune of RM20mil for the covered warrants it has issued. The only way it could mitigate the impact of these losses is to hope that the closing price of Top Glove-C94 is not above its break-even point at the time of maturity of the covered warrants or the hedging position it has taken is sufficient to cover its potential loss. In summary, call and put warrants is a high-roller’s game and comes with big risk. While the IBs too can be at risk and be caught out if underlying share price rises rapidly for call warrants issued or drops drastically for put warrants sold, it is the investors who takes the biggest risk and hence awareness of these products is important before investing in them. Caveat Emptor!

Pankaj C. Kumar is a long-time analyst. The views expressed are the writer’s own.

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