Warrants are attractive in bullish market

Trading on Bursa Malaysia started the new year with a bang. Buoyed by upbeat expectations for global economic growth and driven by cheap money, investors are pouring into equities in the search of higher returns. The headline index, the FBM KLCI, touched a fresh all-time high earlier this month, although it has since retreated slightly on some mild profit-taking.

Under such a bullish trading environment, call warrants are likely to be one of the investments of choice.

Gearing multiplies gains in bull market
Through warrants, investors can gain exposure to the underlying shares for a fraction of the cost. To make warrants even more appealing, issuers have taken to raising the conversion ratio in order to keep the absolute price of the warrants low.

Because the initial cost of the warrant is significantly less, its percentage gain is that much higher. This gearing factor is the biggest attraction of warrants. The higher the gearing multiple, the greater the potential profits.

Earlier this month we saw the listing of a fresh batch of structured warrants, issued by AmBank. The European style call warrants are written on eight underlying stocks — IJM, AirAsia, Petronas Chemicals, Genting, DRB-Hicom, CIMB, S P Setia and Pos Malaysia.

European style warrants can only be exercised at maturity date — in this case, Dec 8, 2011 — as opposed to American style warrants, which are exercisable anytime during the life span. Nevertheless, the difference is not material as few investors actually exercise their options. Most of those who buy warrants are short-term traders looking for quick profits and, more likely than not, have no intention of holding them to maturity.

Settlement for the warrants, if any, will be done by cash at the maturity date - that is, no new shares will be issued. Investors will receive the difference between the price of the underlying share and the warrant’s exercise price adjusted for the conversion ratio, minus expenses.

For example, if prices remain as they are, holders of AirAsia-CL will receive 12 sen per warrant minus expenses at maturity date. On the other hand, investors in CIMB-CK will receive no money when the option lapses. AirAsia-CL and CIMB-CK closed at 18 sen and 15 sen respectively on Wednesday.

Premium will narrow as maturity nears
Based on prevailing prices, all the newly listed warrants are trading at a premium. This is the price that investors pay for having the option for the duration to maturity. Generally speaking, a higher premium suggests that the underlying share price would have to rise by more before the investor makes money.

This premium will narrow as maturity approaches, since the window of opportunity for the underlying share price to appreciate will get smaller and


Since most structured warrants are short-dated investments, this implies that their risks are quite high. Bear in mind too that premiums can dissipate very quickly the moment bullish expectations for the market turn sour.

For instance, PChem-CB currently trades at the highest premium, of roughly 24%, amongst the lot. Based on the prevailing prices and conversion ratio, the implied breakeven price is RM7.85 — well above its current price of RM6.35. This could suggest a relatively higher degree of risk as prices have some way to catch up before the warrants are “in the money”.

What is upside potential from hereon?
As a rule of thumb, price movements for the warrants would mirror that of the underlying shares. Thus, investors should pick the one for which they believe the underlying shares have the greatest upside potential within the life span of the warrants.

Looking at the eight stocks, all have done very well over the past 12 months. For instance, share prices for AirAsia and DRB-Hicom have more than doubled from their lows. All registered strong double-digit gains and are hovering near their highs for the 12-month period. (Shares in Petronas Chemicals have the lowest gains since the stock was only listed in late November 2010).

The question is, of course, how much more upside there is to these stocks from hereon.

Warrant holders have no right to dividends
Investors should also consider the underlying company’s dividend policy when choosing the warrants to invest in. This is especially pertinent to high-yielding stocks since warrants are not entitled to dividends. Prices for the underlying shares will be adjusted for each dividend payment whereas the exercise price and conversion ratio for the warrants will remain unchanged.


Note: This report is brought to you by Asia Analytica Sdn Bhd, a licensed investment adviser. Please exercise your own judgment or seek professional advice for your specific investment needs. We are not responsible for your investment decisions. Our shareholders, directors and employees may have positions in any of the stocks mentioned.

This article appeared in The Edge Financial Daily, January 21, 2011.