The ABC of warrants

One possible reason warrants take a back seat to stocks is the lack of understanding among investors. However, they can be a good alternative investment vehicle to consider.

INVESTORS, Malaysian investors typically, often delve into the know-how of stock investing and unit trust. However, relatively little is said about warrants. One of the many possible reasons that warrants take a back seat to stocks is the lack of understanding among investors.

You may have been told that investing in warrants is risky; that they are more volatile compared to stocks.

However, if you spend some time to learn about them, you will discover that warrants are in fact a good alternative investment vehicle for you to consider. You can make it a part of your investment portfolio and allow yourself room for diversity if you understand it well enough.

An article called "The ABC of Warrants" may seem elementary to some, but it always pays to get your foundation right!

* What is a warrant or call warrant?

A warrant or call warrant basically gives the holder the right, but not the obligation to purchase a specific number of the mother or underlying shares at a specific price within a specific period. They are often included in a new debt issue as a "sweetener" to entice investors.

The holder of a warrant or call warrant will not have any voting or dividend rights as that enjoyed by shareholders. As such you need to be mindful of the fact that as a holder of warrants or call warrants, you will not be entitled to have a say in the company's management decisions.

* Warrant vs call warrants

The typical difference between a warrant and a call warrant is that a warrant is issued by a company for the purpose of raising capital for that company.

Warrants are usually tagged with a longer maturity, usually more than 4 years stretching up to 10 years.

A call warrant on the other hand is issued by third party financial institutions on shares of an unrelated company or shares of a basket of companies. Call warrants usually come with a much shorter maturity period of less than one year.

* American or European?

Warrants or call warrants can also be subdivided into two categories based on their exercise style - either American or European. An American warrant can be exercised at any time up to its maturity date while a European warrant can only be exercised at its maturity date.

What happens when an investor exercises his rights for a company's warrant is that the company will issue new shares to meet the obligations which will result in share dilution. As for a call warrant, the issuer will meet its obligation using outstanding shares. Hence, no new shares will be issued under the call warrant. If the warrants or call warrants are not exercised on expiration, they will turn worthless.

* Value of warrants and call warrants

The value of a warrant is determined by two main factors, its intrinsic value and time value. Its intrinsic value is the difference between the current price of the underlying asset and the warrant's exercise price.

A warrant has a limited life span and as such, when you are looking at the time value, as time passes the value will decrease accordingly until it turns zero on expiration. The factors that will positively affect a warrant's time value are the expected volatility of the underlying stock and the warrant's time to maturity.

* Why invest in warrants?

The main benefit of investing in a warrant is cost leveraging. When you invest in a warrant, you stand to gain from the exposure of the share price movement at only a fraction of its cost. In terms of percentage, a warrant is more sensitive to the market movement compared to its underlying assets.

Therefore, by investing in a warrant, it allows you to benefit from unlimited upside at a lower cost. Apart from that, you can free up your capital to invest in other investments. The downside risk of not being able to exercise the warrant is only the loss of the warrant premium.

* What should you do?

If you want to invest in warrants, you should first understand how the product works and the risks associated with them. The performance of a warrant is closely linked to the price movement of its underlying assets. As such, if you are expecting an uptrend market and have strong confidence in the underlying shares, then the chances of you reaping rewards from investing in warrants is very high.

However, if the market is experiencing a downward trend and the time to maturity of your warrants is limited, then you should be more cautious in buying them. This is particularly crucial if the current market price of the underlying share is lower than the exercise price of the warrant.

A more disciplined way of investing in warrants is to set a time limit for the underlying share to reach your targeted price. If the price does not measure up to your expectations by then, you will need to re-evaluate your position according to your risk/return profile.

In instances where the stock market has been bearish and you have no idea whether the market trend is going to reverse anytime soon, then, you may want to go for warrants with a longer time to maturity. A warrant based on an underlying stock that is in good financial health with good business prospect and has at least 3 years to maturity can be an option for you.

Securities Industry Development Corporation (SIDC), the leading capital markets education, training and information resource provider in Asean, is the training and development arm of the Securities Commission, Malaysia. It was established in 1994 and incorporated in 2007.