New warrants a litmus test for exchange
THE decision by the stock exchange's listing division to defer the processing of listing applications on call-spread warrants is hopefully a routine part of the body's work.
At the weekend, the division said listing applications for the two call-spread warrants issued last week would not be processed until the buck had been passed to the exchange's listing committee for policy consideration.
A warrant in Hong Kong is commonly a piece of paper entitling the buyer to exposure to an underlying share which can be converted into that share, or its cash equivalent, at a pre-determined price (the strike price), over a pre-determined period (the time to expiry).
Investors like warrants because in cash terms they are cheaper than buying the physical share, and for the same cost of buying the physical share, an investor can gain exposure to a greater number of shares.
Normally the downside of a warrant is the cost of buying the instrument. The upside, however, is unlimited. Call-spread warrants alter this risk-reward profile. The loss is still the cost of buying the instrument.
What a call-spread warrant does is to cap the upside, in investment returns, at a pre-determined level. This makes the apparent cash cost of buying the instrument cheaper. By lowering the cost, it heightens the gearing of the instrument, although the total return is capped.
If an investor thinks that over the given period a stock is going to rise dramatically, then unlimited upside is needed, meaning call-spread warrants are inappropriate.
However, if the investor thinks a stock is going to rise moderately within a given range, then a call-spread warrant might be just the ticket, as it can maximise the gain to the investor within the identified share price range cheaper than a normal warrant with unlimited upside.
When considering derivative products, the regulators have been concerned that the interests of retail investors are fully protected.
Hopefully, the listing committee will take the view that call-spread warrants are just another step down the road to greater sophistication in derivative investments in Hong Kong.
Call-spread warrants are very common on the over-the-counter market, which is several times larger than the listed market.
To decide not to allow these instruments to list in Hong Hong would be something of a setback for the territory's increasing dominance in regional derivatives.
It would also be a contradiction in policy, as warrants are already allowed. Call-spread warrants operate on the same principles as normal warrants - they merely modify the risk-reward profile of the instrument.
