Saturday, October 31, 2015

Warrants (Cash Settled Call Structured Warrants) - A Confusing Affair

Warrants in KLSE can be a confusing affair. Perhaps it is done on purpose because it is at the interest of the issuer that buyers lost money in the trade.

What is a warrant? If one trades in US before, it is basically an option - a contract. There are some differences between a warrant and an option. Warrants can't be issued by retail investors unlike options. Option contracts are more standardized compared to warrants - probably the reason why retail investors could issue them.

Option is a form of derivatives and so as warrant. It would be advised for investors to exercise caution when trading warrants.

Few things that warrants traders should pay attention to are:
  • Strike Price
  • Maturity Date
  • Conversion Ratio 
And there are two types of warrants - Call and Put.

For Call warrant, if the underlying shares price is above its strike price, it is then In-The-Money (ITM). For Put warrant, it is ITM, the underlying shares price is below its strike price.

Warrant holders would received cash upon maturity if it is ITM. If it is OTM, their warrants will expire worthless. It is pretty much a bet between sellers (issuers) and buyers (holders).

Confused already?

Today, I'll focus on Cash Settled Call Structured Warrants which are usually issued by bankers.

Before that, lets look at a simpler warrant, AAX-WA (RM 0.055). This is a free warrant given by AirAsia-X to their shareholders and convertible into AirAsia-X shares. Its strike price is RM0.46 and mature on 8/6/2020 and a conversion ratio of 1:1. Current AAX share price as of 30/10/2015 is RM0.205 so it is OTM.

There is value for OTM warrants but I won't go into that (Yea, it is the Black-Scholes thingy).
But lets look at deep ITM warrants (Underlying price > Strike Price) as it is much simpler to value.

Scenario 1 (AAX: RM 0.66)

In this case, AAX-WA would worth around RM 0.20.

Scenario 2 (AAX: RM 0.86)

If AAX price increases to RM0.86 from RM0.66, AAX-WA would worth around RM 0.40. This would mean, a 30% increase in the mother share (AAX) would increase its (AAX-WA) by a whopping 100!!.

Cool ha? also work the other way round. A return to RM0.66 would half your investment. Maybe that is why warrants are attractive to those who believe in the myth of high risk high return.

If upon maturity AAX price is RM1.00, warrant holders would have the rights to purchase AAX shares at RM0.46.
Now, back to Cash Settled Call Structured Warrants - nama pun panjang.

Oh yea, Confused already?
The reason why I asked that is because for most structured warrants I saw, they come with a conversion ratio which adds to the confusion. Lets look at the most actively traded warrants on 30/10/2015. And I'll focus on ITM call warrants.

Out of the four ITM call warrants, FGV-C7 and UEMS-C17 are the ones that are deep ITM. Current FGV price is RM 1.780 while UEMS is RM 1.250. For warrants that is deep ITM, it should be worth very close to the cash received upon maturity.

From the table the fair price for FGV-C7 and UEMS-C17 should be around RM0.230 and RM0.200 respectively. This would show as if both of this warrants are underpriced. Here's where the confusion comes in.

The ratio. If FGV-C7 expires today, instead of receiving RM0.230, warrant holders would have to divide it by the conversion ratio which equals to RM0.059. That's a whopping 3.9 times less!

Less reverse this to compute the breakeven price if a buyer purchased it at RM0.175 today and were to hold it to maturity.

Breakeven Price  = Purchased Price x Conversion Ratio + Strike Price

The breakeven price for FGV-C7 holders (@RM0.175) would be RM2.233. That would also mean, FGV (the mother share) price would have to make at least a 25% increase. I am quite sure during that rally FGV-C7 would rally as well. That would make it a greater fools game, a game of musical chair and a zero sum game.

I won't bother to write about OTM warrants or those which are close to the strike price because the Greek characters would come into play. That's a lot more complicated and Black-Scholes has proven to be unuseful - would be a less harsher word.

Confused already?

Disclosure: I have no positions in the above warrants mentioned and have no intention to purchase them within the next 72 hours.

1 comment:

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