An Explainer

In recent days, the Malaysian market has been abuzz with news on warrants. Investors’ interests in warrants have skyrocketed after Supermax Corp Berhad’s and Top Glove Berhad's warrants dominated Bursa Malaysia’s top gainers list.

A warrant gives the right, but not the obligation, to its holder to buy or sell a certain asset at a fixed price (called strike price) provided the price of the asset is traded at certain levels during a specific period or at specific date and time. A warrant is said to have been exercised if such buying or selling take place under the terms of the warrant. The asset which a warrant is based upon is usually called the underlying asset; if the underlying asset is a share, it can also be referred to as the “mother share”.

In other words, a warrant derives its values from its underlying asset or security. A warrant is also a leveraged financial instrument as it provides exposure to the underlying asset for a fraction of the underlying asset’s price.

Warrants also come in a few “styles”. The more popular styles of warrants in Malaysian market are European-style and American-style. European-style warrants can only be exercised on the expiry date; the date beyond which a warrant is no longer valid. American-style warrants on the other hand may be exercised during a period of time before expiry date.

Warrants come with a variety of features. They can be based on a range of assets or securities such as shares, a basket of securities (such as stock indices), currencies or even commodities.

In Malaysia there are two types of warrants: company warrants and structured warrants.

COMPANY WARRANTS

A company warrant is issued by a company, and gives the holder the right to purchase the company's shares at a fixed price on a date or a period before the expiry date.

This warrant has a maturity date (up to 10 years) after which it expires and becomes worthless unless the holder had exercised to subscribe for the new shares before the maturity date.

Company warrants are not usually traded and have no market makers.

STRUCTURED WARRANTS

Unlike company warrants, a structured warrant is issued by a licensed third party issuer, like qualified brokerages, investment banks and other financial institutions.

Structured warrants can have underlying asset in the form of single security, basket of securities, indices, commodity, or currency. Exercising a structured warrant based on share does not affect the number of shares in a company.

While structured warrants can be exercised, investors don’t usually buy structured warrants for such purpose. In fact, structured warrants are used by investors to quickly take advantage of market movements and are meant to be short term investment tools. Being a leveraged product, a structured warrant allows an investor gain a large position in a stock or index (such as Hang Seng Index) with a relatively small sum of capital.

On top of that, all structured warrants have market makers to ensure liquidity. When you acquire a warrant the price you pay is called the premium of the warrant.

Call Warrants & Put Warrants

All structured warrants can be categorised under two major types known as Call Warrants (C-) and Put Warrants (H-), based on whether a warrant confers the right to buy or the right to sell.

Call Warrants

A call warrant gives the investor the right to buy the underlying asset from the warrant issuer at a fixed price, known as the exercise or strike price, on a future date provided the price of underlying asset is above the strike price.

Everything else equal, the premium or price of a call warrant will increase if the underlying asset price increases and will decrease if the underlying asset price decreases.

Put Warrants

A put warrant gives the investor the right to sell the underlying asset to the warrant issuer at the exercise price on a future date provided the price of underlying asset is below the strike price.

Everything else equal, the premium or price of a put warrant will increase if the underlying asset price decreases and will decrease if the underlying asset price increases.

One needs to take note that the price of underlying asset is not the only factor that can affect a warrant’s pricing. Other factors include (but not limited to) market volatility and time decay. Everything else equals, a higher market volatility (or simply “vol”) means higher warrant prices, whether it’s a put or a call. To put it succinctly, high market vol is beneficial to warrant holders in general. Time decay on the other hand always pose a negative effect on the price of the warrant, we shall talk about time decay later when we discuss about risks involved in structured warrant investing.

As such, a structured warrant’s price might not move in a way as expected for a given movement in underlying security. For example, the price of a call warrant may decline even though the mother share price increases during the day. This could be due to a drop in market volatility (which will affect the price of a warrant negatively). In addition, a structured warrant is a market of its own; where at times the demand and supply might cause the price of a warrant to deviate from its fair price.

Here are examples of how Structured Warrants work:

Call Warrants

• Assuming in one month you plan to buy 100 boxes of face masks. It is currently worth RM5,000.
• As you are expecting the prices of face masks to go up, you pay 5% of its worth (RM250) to lock in that price now.
• After 1 month, the price of face masks does go up and these 100 boxes are now worth RM5,500.
• You effectively enjoy a gain of RM500 if you sell the masks at the higher price right away, with a smaller RM250 initial outlay (as opposed to actually buying the face masks with RM5,000 upfront).
• The RM250 cost in this case is the price of a call warrant which has an exercise price of RM5,000, meaning you have the right to buy the face masks (the underlying) at RM5,000.
• However, if the price of the face masks declines to RM4,000 instead, you will not exercise this right to buy as it is cheaper for you to buy the face masks from the market, meaning your earlier payment of RM250 is considered worthless.

Put Warrants

• On the other hand, you plan to sell 100 boxes of face masks currently worth RM5,500 in 6 months time.
• As you are expecting the prices of face masks to go down, you pay 5% of its worth (RM275) to lock in that selling price now.
• After 6 months, the price of face masks does indeed decline by 20% and these 100 boxes are now worth RM4,400.
• However, you sell the face masks at RM5,500 regardless, pocketing a gain of RM1,100, with a smaller RM275 initial outlay.
• The RM275 cost in this case is the price of a put warrant which has an exercise price of RM5,500, meaning you have the right to sell the face masks (the underlying) at RM5,500.
• However, if the price of the face masks increases to RM6,500 instead, you will not exercise this right to sell as it is more lucrative for you to sell the face masks to the market, meaning your earlier payment of RM275 is considered worthless.