The Magazine Covering All Aspects of The Indian World


December 2005 - January 2006

Editorial Business Forum Political News Dispatches & Reports Letters Spotlight Lifestyle Spiritual Health Dream Homes India Sport Scene
All Sections
Issue Archive

December 2005 - January 2006


Business Forum

Want to add some sparkle to your portfolio? Introducing: Warrants...

by Jateen Patel, Director, Berkeley Capital


Neither any information nor any opinion contained in this paper constitutes an offer to buy or sell or a solicitation by or on behalf of Berkeley Capital and/or any of its affiliates (together “BCR Group”) of an offer to buy or sell any security, product, service or investment. Any opinions expressed in this article do not constitute investment advice and independent advice should be sought where appropriate.

Investors looking to take on more risk in exchange for the potential for greater returns might seem like rare beasts in this day and age, but the growth in the warrants sector in recent years indicates that this is not the case.

Warrants can be an attractive area for both investment and speculation but there is a widespread lack of understanding as to how they actually work. Traditional warrants can be issued by a variety of companies but historically the market has been dominated by the investment trust sector.
Covered warrants were made available to UK private investors for the first time when they were introduced on the London Stock Exchange in October 2002. These versatile instruments, which have already proved popular in other countries, offer a variety of investment solutions for a range of investors.

One of the questions many investors ask is where the name comes from – why are they called covered warrants? The term ‘covered’ denotes the fact that when the issuer sells a warrant to an investor, they will often ‘cover’ (hedge) their exposure by buying the underlying stock in the market, or by using other instruments. Covered warrants have on average a life of six to twelve months, although some have a longer (or occasionally open-ended) lifespan.
They can be bought and sold at any time during their lives.

What is a covered warrant?
Covered warrants are issued by financial institutions and then listed as fully tradable securities on the London Stock Exchange. A covered warrant gives the holder the right (but with no obligation) to buy or sell an underlying asset, at a specified price, on or before a predetermined date.
For many investors, covered warrants will seem similar to options. Covered warrants typically have longer maturities than options, and are issued over a wider range of assets. The terms are also more varied – covered warrants are highly flexible and can be issued with terms structured to meet market demand. For example, in the same market segment as covered warrants are certificates, which are ungeared and provide a lower risk exposure. With covered warrants you cannot lose more than your initial investment. Your maximum loss is known in advance, and there are no margin calls, i.e. further payments to maintain your position. This differentiates covered warrants from some other forms of derivatives.

Types of covered warrants
Stock warrants

Covered warrants on single stocks account for a little over half of those available. The main focus is on popular UK ‘blue-chip’ shares such as BP, GlaxoSmithKline, Lloyds TSB, Royal Bank of Scotland, and Vodafone, where there are numerous competing warrants from different issuers. There are also some covered warrants on popular shares in other markets, including US stocks such as Microsoft and Yahoo.

Baskets

For exposure to a particular theme or sector, a number of securities are sometimes grouped together in a ‘basket’. Investors can then obtain exposure to this basket simply and efficiently by buying one single security in the form of a covered warrant.

Index

In most covered warrants markets around the world, the most actively traded warrants tend to be those on the main domestic market index. In the UK, the FTSE 100 Index has been a consistently popular underlying. Covered warrants have also been issued over other UK market indices such as the FTSE 250 Index, and a range of overseas indices. Investors wishing to gain exposure to the Dow Jones Industrial Average, Nasdaq 100 Index, Nikkei 225 Index, Hang Seng Index, DAX Index, CAC 40 Index, and others can do so using UK covered warrants. There are also warrants that give exposure to house prices via the Halifax house price indices. You can gain exposure to the wider UK house prices and profit from the increases and decreases.

Commodity

It can be difficult for private investors to gain exposure in sterling to major commodities such as gold, silver and oil. Using covered warrants it is possible for investors to take positions on these commodities, in small size and in sterling.

Currency

The same applies to currencies. Covered warrants are available on a range of exchange rates, including sterling/dollar, sterling/euro and yen/dollar.

Example: Gold Warrants
Gold warrants allow investors to gain leveraged exposure to movements in the price of gold – either on the upside with call warrants, or on the downside with put warrants. The warrants are priced in pence, with no minimum trade size. The price of gold is influenced by supply and demand expectations. Gold supply comes from mine production figures (typically around 2,500 tonnes a year) plus gold recycled from scrap. Demand for gold is driven by fabrication of gold jewellery, coins and bars for investment purposes.

Unlike tracker certificates, a warrant has a fixed expiry date. Upon expiry, any positive value in the warrant will automatically be paid out to the warrant holder. The payout formula for a gold call warrant is as follows:

payout per warrant =  [price of gold at expiry – warrant exercise price]/parity

The parity for the gold warrant is 100. Investors should note that the formula above gives a dollar amount, which is automatically converted into sterling by using the GBP/USD exchange rate at expiry.

For example, consider the price of a $400 gold call warrant if, at expiry, gold was trading at $450 and the GBP/USD exchange rate was 1.90. In this case the price per warrant at expiry would be ($450-$400)/100 = $0.50. Converting this into Pounds, with an exchange rate of 1.90, gives a payout amount of 26.3p per warrant. Had the price of gold been below $400 at expiry, the warrant would have expired worthless. For a put warrant, the payout amount is determined by how far the price of gold lies below the warrant exercise price at maturity. For example, the holder of a $400 gold put warrant would be paid 26.3p if the price of gold was $350 at expiry (and the GBP/USD rate was also 1.90).

Remember there is no need to hold a warrant to expiry as the price of a gold warrant moves with the price of gold on a second by second basis. This allows profits to be taken following a favourable move in gold (or losses cut following an unfavourable move) at any time. As gold warrants offer leveraged exposure to the price of gold, they are riskier investments than a corresponding investment in an unleveraged tracker certificate. If you are correct in your investment view, the rewards, of course, should be higher. Other market factors such as the level of interest rates and market volatility can also influence the price of the warrant.


How to start using covered warrants
When investing in warrants investors should first consider the following questions:

• What am I trying to achieve?
• How much risk/leverage am I prepared to accept?
• What is my time frame?
• How much can I afford to lose?

When investors have answers to these questions they can begin to look at the range of available warrants to find which one best fits their requirements. One of the most attractive elements of the covered warrants market is that you can buy and sell these instruments as easily as you would trade ordinary shares. The costs of dealing in covered warrants are relatively low, similar to those of an execution-only dealing service. Indeed, most brokers will deal in covered warrants for the same price as they deal in ordinary shares.


Trading covered warrants

You trade warrants through a stockbroker and not with an issuer. You can choose between advisory and execution-only brokers, as well as between brokers that offer internet/telephone and telephone-only services. The trading day runs from 8.15am until 4.30pm. All covered warrants are CREST-settled in T+3 like equities. There is no need to set up a separate, dedicated account, as you have to do for spread betting. Unlike equities, warrants are not subject to stamp duty.
To ensure that you can track the market effectively there are a number of online services available from the London Stock Exchange, the major issuers and a number of information service providers. Newspapers and popular investment magazines also publish the prices of warrants on a regular basis – see ‘Places to go for more information’.


Exercising covered warrants

UK covered warrants are cash-settled instruments. This means that the issuer will pay a cash amount for the intrinsic value of the warrants at the expiry date, or on exercise, if sooner. In other words, although the terms of Call warrants are usually expressed as a right to buy, and Put warrants as a right to sell, they are more accurately a right to receive a cash payment equivalent to the difference between the exercise or strike price and the value of the underlying asset at expiry.


Risk Warning

Before you trade, you should be satisfied that warrants are suitable for you in the light of your circumstances and financial position. If you are in any doubt you should consult an appropriately qualified financial advisor. The following summary cannot disclose all the risks and other significant aspects of warrants.

Investment risks

Warrants are not suitable for all investors. They can be volatile investments and may expire worthless. You should not deal in warrants unless you understand their nature and the extent of your exposure to risk. You should not buy a warrant unless you are prepared to lose all of the money you have invested plus any commission or transaction charges incurred.

Leveraged returns

Warrant investors should be aware that, if the underlying instrument to the warrant moves in the opposite direction to that anticipated by investors, the losses incurred by the warrant may be greater in percentage terms than those incurred by the underlying itself.

Limited life

Warrants have a limited life, as denoted by the expiry date of each issue. After this date, warrants can no longer be traded. It is therefore important that the forecast move in the underlying instrument of the warrant take place during the life of the warrant. It must also be noted that warrants experience time decay (erosion of their time value) throughout their life, and that the rate of this decay accelerates as warrants near expiry.

Currency risk

The foreign exchange rate will affect the price of a warrant over a commodity as it is determined in the local currency of the underlying and then converted into sterling.

General market risks

In addition to movements in the underlying security, factors such as movement in interest rates, currencies and implied volatility have an impact on the price of warrants.


Final thoughts

Careful groundwork will bring long-term rewards. The usual investment disciplines apply. Set clear goals and objectives, particularly prices at which to lock in profits and cut losses. Following them will be important in ensuring that warrants prove a successful instrument for enhancing and protecting your investment returns. For a better understanding of covered warrants, please refer to Covered Warrants – a Detailed Guide. This guide explores warrant dynamics as well as examining trading strategies in more depth and applications for the investor.


For more information
All participants in the covered warrants market stress the need for education to help investors understand covered warrants and use them successfully. There are a number of websites which offer comprehensive background information dealing with what covered warrants are and how they work, alongside more specific price information and technical analysis:

• The McHattie Group – www.coveredwarrants.co.uk or www.mchattie.co.uk
• The main current issuers – DrKW, Goldman Sachs, JP Morgan, SG and UBM
 

More Business Forum

More articles by Jateen Patel, Director, Berkeley Capital

Return to December 2005 - January 2006 contents

 
 
Copyright © 1993 - 2017 Indialink (UK) Ltd.