Understand Structured Warrants Before Investing

Before you invest in a structured warrant, make sure you have a thorough understanding of how the instrument works and the risk elements.

A warrant is an investment instrument which gives the holder of the warrant the right, but not the obligation, to buy (or sell) a given quantity of the underlying asset from (or to) the issuer at a pre-determined price on or before its pre-determined date. The pre-determined price is also known as the exercise or strike price and the pre-determined date is the warrant's maturity or expiry date.

Structured warrants are issued by third parties on the shares of an unrelated company. The underlying assets of structured warrants listed in Singapore are mainly indices and local and foreign shares. In Singapore, structured warrants traded are of European style, meaning you can only exercise the warrant on the expiry date of the warrant.

Call Warrant and Put Warrant

A call warrant gives the holder the right to buy an underlying asset from the issuer on the expiry date at a pre-determined price.

If the market price of the underlying asset is below the call warrant's exercise price that is, the call warrant is "out-of-the-money" on the warrant's expiry date, the warrant holder is not required to buy the underlying asset from the issuer. But if the market price of the underlying asset is above the exercise price, that is, the call warrant is "in-the-money" on the warrant's expiry date, then it is to the warrant holder's advantage to buy the underlying asset from the issuer at the lower exercise price and sell it in the market to make a profit.

A put warrant, on the other hand, gives the warrant holder the right, but not the obligation, to sell the underlying asset to the issuer at the pre-determined exercise price on the expiry date. If the market price of the underlying asset is below the warrant's exercise price on the warrant's expiry date, it would be to the advantage of the warrant holder to buy the underlying asset in the market, then sell it to the issuer at the higher exercise price and make a profit.

Investors typically buy call warrants if they expect the price of the underlying asset to rise in the future before the warrants' expiry. If the price of the underlying asset does rise, the price of the call warrant would probably also rise and they make a gain by selling the call warrant into the market.

Alternatively, they can exercise their right to buy the underlying asset from the issuer on expiry. However, if the price of the underlying asset falls, the price of the warrant would also probably fall. It would also not be profitable for the investor to exercise the warrant on expiry.

The opposite applies to put warrants. Investors who feel that the underlying asset has been overpriced and expect the price to fall soon would buy put warrants. If the price falls, they can sell the put warrants in the market at a higher price than what was paid for them. But if the price of the underlying asset rises, the warrant's price would also probably fall. It would not be profitable for the investor to exercise the warrant on expiry.

Factors Affecting the Price of Structured Warrants

Generally, there are five factors that will affect the pricing of a structured warrant – both put and call warrants. Of the five factors, any changes to the underlying asset price, time to expiry and implied volatility will have the most impact on the warrant price. The following points explain how each factor would affect the price of a structured warrant, assuming all other factors remain unchanged.

1) Underlying asset price – as the price of the underlying asset increases, the price of a call warrant should rise. Conversely, as the price of the underlying asset decreases, the value of a call warrant should fall. The opposite is true for put warrants. Do note that warrant prices are more volatile than prices of the underlying assets.

2) Time to expiry – The longer the time of expiry, the more time there is for the price of the underlying asset to possibly move in favour of the warrant holder. Hence, the prices for warrants prices with longer expiry periods are generally higher than warrants with shorter expiry periods. Also, the value of a warrant deteriorates at increasing rate rate as it approaches date to expiry.

3) Implied volatility – The higher the expected volatility of the underlying asset, the higher will be the warrant price. This is because a higher volatility means there is greater probability of the price of the underlying asset surpassing the exercise price.

4) Interest rate – Rising interest rates generally result in more expensive call warrants and cheaper put warrants. Interest rates reflect the cost of funding the underlying asset. By buying a call warrant, you can defer paying for the underlying asset until the warrant’s expiry date, and invest the funds elsewhere during this period. As interest rates rise, more interest can be earned on the funds, so the call warrant is worth more to you. The effect of an interest rate rise is the opposite for put warrants, as you are deferring the receipt, rather than the expenditure of the funds.

5) Dividend – Investors in warrants, whose underlying asset are shares, do not receive the dividends paid on the underlying shares. A correctly priced warrant should already factor in expected dividend assumptions. Generally, the higher the dividend, the lower the price of a call warrant. In the case of put warrants, higher dividends typically raise the price of a put warrant.

How Listed Structured Warrants are Settled In Singapore Upon Expiry?

In Singapore, settlement of both call and put structured warrants are typically done in cash and not in the underlying asset. Structured warrant holders whose warrants expire in-the-money will get the difference between the settlement price and exercise price, but not the underlying asset itself (which means that structured warrant holders do not, at any point, hold shares of the underlying asset.)

Key Benefits of Structured Warrants

The main advantage of structured warrants is the leverage or gearing it offers. Structured warrants offer investors exposure to the underlying asset, and are attractive as they are usually priced at a fraction of the underlying asset.

For example, say share ABC is trading at $7.15 and the call warrant for this share is trading at $1.24. Assuming the share price increase by $0.15 to $7.30 and structured warrant increases by $0.10 to $1.34. The percentage gain for the shares would be 2%. However, with a $0.10 gain, the percentage gain of the structured warrant would be 8%.

Structure warrants also offer investors limited downside losses. The maximum potential loss to an investor is the warrant price, which is usually a fraction of the asset price. For a call warrant, an investor could lose the entire warrant price when the underlying asset price is lower than the exercise price at warrant expiry, making the warrant worthless.

Key Risks of Structured Warrants

While the leverage effect described earlier potentially magnifies gains, it also potentially magnifies your losses.

If we reverse the outcome of the example above and say the prices of the share fall by $0.15 and the structured warrants by $0.10, the percentage loss for the share price would be 2%, while the loss on the warrant would be 8%.

Besides the potential losses from the leverage effect, other risks associated with structured warrants include:-

(a) Limited life: Warrants have a limited life and will expire without any value if it is not exercised. Therefore, it is important that you select a structured warrant that has sufficient time to expiry to math your investment objective. Be particularly careful if you are considering whether to invest in a warrant that is near expiry as the value of a warrant deteriorates at an increasing pace as it approaches the expiry date, assuming all other factors remain constant.

(b) Credit risk: Each warrant is a contract between the warrant issuer and the holder. You are therefore exposed to the risk that the issuer will not perform its obligations when you exercise the structured warrants. Therefore, do consider the credit risk associated with the warrant issuer.

(c) Liquidity risk: This is the risk that you may not be able to sell your structured warrants for a reasonable price in the market. This could be because there are insufficient orders to buy your structured warrants, or the price at which others are prepared to buy them is low.

Conclusion

Structured warrants are a type of option issued by a third-party financial institution. Structured warrants can never be a complete substitute for the underlying asset. Because of the leverage nature of the warrant, both the potential gains and losses can be very significant.
Hence before investing in structured warrants, make it a point to understand the features of structured warrants, your risk tolerance and your investment objective. Do not invest in any product that you do not understand.

This is provided by the Singapore Investment Banking Association and the Monetary Authority of Singapore under the MoneySense national financial education programme.