Traditional corporate equity warrants

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Caren Golden
5 years ago
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1 Traditional corporate equity warrants Summary by Mr.LikeStock Major Content from Dec 2014

2 Introduction Warrants are for experienced investors who have an understanding of risk, and who want to exploit the gearing potential in warrants. This is one of the more hidden - and thereby inefficient - areas of the market, offering interesting opportunities to the shrewd investor. The theory of Warrants 2

3 Warrants are fantastic what are warrants? Warrants exist in a world between shares and options. They share some of the turbo-charged performance of options, without taking on so much of the complexity and risk. The great attribute of warrants is a feature called gearing. Gearing is what adds rocket fuel to the performance of warrants - and gets the heart racing. Why invest in a share that rises 25%, when you can invest in its warrant that soars over 100%? The theory of Warrants 3

4 why isn't everyone investing in warrants? 1. The warrant world is obscured with confusing vocabulary. 2. there is very little written about warrants: neither general information nor detailed research. The theory of Warrants 4

5 What is a warrant? Warrants are like long-term options. They are attractive to speculators because they exaggerate the movements of the underlying equity if the share moves up a bit, the associated warrants can increase a lot! The theory of Warrants 5

6 Advantages of warrants over shares the magic of gearing TR Property shares TR Property warrants Price: 17 Feb p 4.50p Price: 12 Jan p 13.30p The theory of Warrants Increase (%) 49.6% 195.6% 6

share and warrant price performance The major attraction of warrants therefore is this feature of gearing - they track, but magnify, the share price movements.

7 share and warrant price performance The major attraction of warrants therefore is this feature of gearing - they track, but magnify, the share price movements. In bull markets, 'smart money' will often flow into warrants, instead of shares, to gain from the turbo-charged performance of warrants. The theory of Warrants 7

8 Further attractions of warrants Hedging Inefficient market Lack of research Well-suited for private investors The theory of Warrants 8

9 Disadvantages of warrants Gearing Warrants can rise spectacularly fast; they can also plummet just as quickly. Complexity complexity sometimes breeds opportunity. Liquidity No income Warrant-holders get no dividends or any other type of income. Limited rights Lack of information Dilution The theory of Warrants 9

10 Fundamentals - warrant terms Underlying asset. This is the asset that the warrant-holder will receive on conversion of the warrant. Conversion ratio. This details the number of shares that a warrant-holder will receive upon exercise of one warrant. Exercise price. Sometimes called the subscription price. The price that must be paid to exercise the warrant and receive the allotted shares. Exercise dates. Describes exactly when the warrant may be exercised. Exercise period. The period over which the subscription rights are valid. The theory of Warrants 10

A pillar diagram The relationship between the warrant and underlying share can be represented (below) in what we will call a 'Pillar Diagram'. Directly.

11 A pillar diagram The relationship between the warrant and underlying share can be represented (below) in what we will call a 'Pillar Diagram'. Directly. The left column represents buying shares directly in the shares market, where the shares' market price is 120p. Via the warrant. The right column represents acquiring the shares by first buying the warrants (at 50p), and then exercising the warrants (by paying 100p to the company to receive one share). The theory of Warrants 11

12 intrinsic value and parity ratio intrinsic value = share price - exercise price in money ABC plc warrant Share price: 120p Exercise price: 100p Warrant price: 50p When the share price is 120p, and the exercise price is 100p, the intrinsic value of the warrant is said to be 20p. If the share price increased to 200p, the intrinsic value of the warrant would be 100p. However, if the share price fell to 100p, or below, the intrinsic value would fall to zero. out money The theory of Warrants 12

13 Basic analysis Warrant prices are linked to the prices of the underlying shares. But the exact nature of the link is sometimes difficult to fathom, and the link is not always a strong link. A share may be deemed to be good value, but that doesn't necessarily make the warrant also good value. The theory of Warrants 13

14 Basic analysis the section tries to answer questions like How much will a warrant be worth at expiry? Is this warrant cheap? Which of these two warrants is better to buy? Should I buy the warrant or share? What will happen to the warrant price if the underlying equity increases 20%? The theory of Warrants 14

15 A dangerous attraction of warrants dangerous attraction of warrants is that they commonly have low prices The problem here is that it attracts a 'penny share mentality', which equates cheap price with cheap value. the warrant will expire worthless! The theory of Warrants 15

16 Analysis - time value and premium No free lunch - even in the warrant market The warrant's price will rarely be - and never significantly so - lower than its intrinsic value. The reason is that this would create a riskless arbitrage: investors could buy the warrants and exercise them into shares If a warrant is deep in-the-money, or expires in a very short time, a warrant price may trade at a small discount to its intrinsic value. In theory, this presents an arbitrage opportunity; in practice, any potential profit would be offset by the transaction costs. The theory of Warrants 16

17 The time value of a warrant The normal situation is for the warrant price to be quite a bit more than the intrinsic value. Why is this? Why are investors willing to pay, sometimes significantly, more than the intrinsic value for a warrant? The reason is time value. warrant price = intrinsic value + time value The theory of Warrants 17

18 Decay of Time value The theory of Warrants 18

19 Expiry and the passage of time the value of a longer-dated warrant will resist time decay better than a shorter-dated warrant The theory of Warrants 19

20 pay a premium (time value) Investors are willing to pay a premium (time value) over the intrinsic value because of the remaining life of the warrant. As the exercise price is fixed, any future increase in the share price up to the warrant expiry, will be reflected by commensurate gains in the intrinsic value. The theory of Warrants 20

21 In the example the current intrinsic value of the warrant is 20. If the warrant was due to expire tomorrow, then like as not the warrant would be priced around 20 as well. But if the warrant still has, say, 4 years before expiry, there's a very good chance that the share price will increase significantly over that time, and the intrinsic value rise to 50, 100, or who knows? In the example, the warrant is priced at 50, which, given that the intrinsic value is 20, gives the warrant a time value of 30. The market is therefore telling us that investors are willing to pay 30 for the potential for futures gains in the share price (and thereby gains in the intrinsic value), before expiry of the warrant. The theory of Warrants 21

22 An out-of-the-money warrant If a warrant is out-of-the-money, by definition a warrant has no intrinsic value. In this case, the time value component accounts for all the warrant price. A couple of comments on time value 1.Time value is a tricky thing. How much are investors willing to pay for a warrant with an exercise price of 100 and a life of 3 years? How much for a warrant with a life of 5 years? How much will they be willing to pay this time next year? No one knows. 2.It is not possible to compare warrants knowing only their time values. One warrant with a time value of 20 is not necessarily 'cheaper' than a warrant with a time value of 30. We need to know more information about the relationship between the share, warrant and exercise prices. The theory of Warrants 22

Warrant premiums the warrant premium measures how much more expensive it is to acquire a share via the warrant, rather than buying a share directly.

23 Warrant premiums the warrant premium measures how much more expensive it is to acquire a share via the warrant, rather than buying a share directly. The warrant premium is a similar measure to time value, except - 1.Unlike time value, the premium captures the extra information about the state of in or out-of-themoney of the warrant. 2.Warrant premiums can be compared directly with each other. As such, the premium can be regarded, perhaps rather crudely, as measuring the 'expensiveness' of a warrant. For example, a warrant with a premium of 20% can be said to be cheaper than one with a premium of 30%. premium = 100 x ((warrant price + exercise price) - share price) / share price The theory of Warrants 23

24 A high premium warrant Warrants tend to have high premiums when they are deep out of-the-money, and low premiums as they become more in-themoney. Warrant premiums, on individual warrants, and in aggregate across the whole warrant market, are a good barometer of the mood of the market. When investors feel bullish premiums tends to rise, when they are bearing, premiums fall. In October 2001, the average premium on warrants listed on the LSE was 47.0%. The theory of Warrants 24

25 Analysis - gearing This is where warrants get interesting! If a share price increases, say, 10%, how much will an associated warrant rise? gearing = value of exposure to asset / cost of exposure Simple definition of gearing If a warrant is priced at 10p, and the underlying share is priced at 50p, the gearing is 5 times. The price of one warrant (10p) offers exposure to one share (of value 50p). warrant gearing = share price / warrant price The theory of Warrants 25

26 The effect of share price on gearing Gearing decreases as the share price increases Warrants tend to have the greatest gearing when they are at or out-of-the-money warrants deep in-the-money (share price high above the exercise prices) tend to be unattractive - because they have a very low gearing. The theory of Warrants 26

27 Using the gearing calculation in practice gearing = 366 / 145 = 2.52 Gartmore Euro IT shares Gartmore Euro IT warrants Notes Price: 23 Mar p 145p Calculated gearing: 2.52 Price: 21 May p 206.5p Increase (%) 17.2% 42.4% Actual gearing: 2.46 The gearing of 2.52 implies the warrant price will increase 2.52 times greater than a given rise in the underlying share. For example, a share price rise of 10%, will see a rise of about 25% in the warrant price. The theory of Warrants 27

28 the premium on the warrant was near zero. TR Property shares TR Property warrants Notes Price: 17 Feb p 4.50p Calculated gearing: 8.93 Price: 12 Jan p 13.30p Increase (%) 49.6% 195.6% Actual gearing: 3.94 The exercise price on the TR property warrants is 47.5p. Knowing this we can calculate that the premium on the warrants at the beginning of the period was 29.0%. Note: it is common for a warrant premium to decrease when the share price rises. The theory of Warrants 28

29 Analysis - summary The section on analysis in this course started by looking at the simple indicator time value, and then step-by-step refined the analysis by 1. adding further factors affecting the value of a warrant (such as the life of the warrant), and 2. normalizing the factors to allow for easy comparison between warrants. The theory of Warrants 29

30 factors affecting warrants Characteristic or indicator maturity parity ratio time value premium gearing implied gearing break-even CFP share price growth Desirable (for warrants) long positive low low high high low low high The theory of Warrants 30

31 Investing strategies Speculation Gearing switches Hedging switches Arbitrage The theory of Warrants 31

32 Dealing in warrants Liquidity - size of the bid-offer spread. Turnover - The normal daily turnover in warrants can be very low opportunities can be found, that just don't' exist in the more efficient shares market. Warrants can also be particularly suitable for individual investors. The theory of Warrants 32

33 Thai Broker Paper (Warrant) The theory of Warrants 33

34 Thank You Q & A The theory of Warrants 34

covered warrants uncovered an explanation and the applications of covered warrants

covered warrants uncovered an explanation and the applications of covered warrants Disclaimer Whilst all reasonable care has been taken to ensure the accuracy of the information comprising this brochure,