Warrants

There are two main types of warrants: equity warrants and derivative warrants. Warrants are an instrument which gives investors the right - but not the obligation - to buy or sell the underlying asset (e.g. a stock) at a pre-set price on or before a specified date.

Types of warrants

• Equity warrants

Equity warrants are issued by a listed company.  They give holders the right to subscribe for equity securities of the issuer.  Equity warrants are often issued together with new shares in IPOs, or distributed together with the shares acquired for any dividend payment, bonus issue or rights issue. Equity warrants have a life of one to five years. When these warrants are exercised, the listed company will issue new shares to their holders.

• Derivative warrants

Derivative warrants are issued by a third party, generally a financial institution. Different with Equity warrant, it generally divided into two types: calls and puts. Under the existing Listing Rules, derivative warrants have a maximum life of five years, but most derivative warrants in the market tend to have shorter lives – normally six months to two years. Derivative warrants can be linked to a single security or a basket of securities, stock indices, currencies, commodities or futures contracts (like crude oil futures). Almost all derivative warrants currently traded in Hong Kong are cash-settled, rather than a purchase or sale of the underlying asset. Derivative warrant issuers are required to appoint a Liquidity Provider for each one of their listed derivative warrant. Liquidity Providers provide liquidity for derivative warrant issues by means of continuous quotes or quote request.

Pros and Cons of warrants investment

Warrants investment involves leverage or gearing. Warrants usually cost a fraction of the price of the underlying asset, yet the value of a warrant may increase or decrease to a much greater extent than the changes in the price of the underlying asset. This means greater potential profit compared to trading in the underlying asset and also the risk of losing the entire purchase price of the warrant. Although warrants can potentially multiply both gains and losses, the maximum loss to warrants buyers is limited to the initial amount paid for the warrants.

The mechanism of derivative warrant

Those who buy call warrants usually hold a bullish view of the price of the underlying asset. To profit from the purchase of a call warrant the holder of the warrant may sell the warrant in the market or wait until the expiry date. At the expiry of a call warrant, if the price of the underlying asset as calculated under the terms of the derivative warrants is higher than the derivative warrant’s exercise price, the call warrant will be exercised and the holder will be entitled to the difference in cash, assuming the derivative warrants us cash settled. The cash amount will be equal to the positive difference between the closing price of the underlying asset and the exercise price if the derivative warrant adjusted by the entitlement ratio. If the price of the underlying asset at expiry is less than the exercise price the
derivative warrant will expire worthless.

Conversely, those who buy put warrants usually hold a bearish view of the price of the underlying asset. Like the call warrant, the holder can sell the put warrant in the market or wait until expiry. At the expiry if a put warrant, if the price of underlying asset as calculated under the terms of the derivative warrant us lower than the derivative warrant’s exercise price, the out warrant will be exercised and the holder will be entitled to the difference in cash, assuming the derivative warrant us cash settled. The cash amount will be equal to the positive difference between the exercise price of the derivative warrant and the closing price of the underlying asset adjusted by the entitlement ratio. If the price of the underlying asset at expiry is higher than the exercise price the derivative warrant will expire worthless.

The key factors and risk of derivative warrant

Some major factors that affect the theoretical price of a derivative warrant include:

• The price of the underlying asset and the exercise price,
• The volatility of the underlying assert price,
• The time remaining to expiry,
• Interest rates, and
• The expected dividend payments on underlying asset.

Like other securities, the price of a derivative warrant may also be affected by the supply of and demand foe the derivative warrant itself. Various mathematical formulae are used by the market players to calculate the theoretical prices of derivative warrants and those theoretical prices often differ from the market prices.

Investors should understand the above-mentioned factors, and consider the following risks before trading in derivative warrants, include:

• Issuer’s credit risk
• Gearing risk
• Limited life and time decay investment
• Volatility of underlying asset and market forces could significantly
  affect the price.

Trading in derivative warrant involves high risks; investors are strongly advised to have a thorough understanding of the product as well as the terms and conditions of the derivative warrant being offered and/or consult their brokers or professional investment advisers before trading.