Sharing in the action with warrants

LAST week we mentioned a warrant and defined it loosely as a long-term option.

In addition, a warrant gives you the right to buy shares at a fixed price in the future. As with options, warrant prices are likely to move in the same direction as the underlying share price, either up or down.

One difference between an option and a warrant, is that most warrants are issued with a longer time to the expiry day, the last day on which the warrant can be exercised.

This means the investor has a longer time to bet on the value of the share going up.

Another difference is that warrants are issued by a company and hence the number available for trading depends on the issue size.

In contrast, the number of options available depends on supply and demand.

Now for the technicalities of the warrant.

Let us say a share price is $2. The warrant is to be exercised at $1.80 for the shares in any year up to six years from now.

To ''exercise'' this right, the investor purchases a warrant. If the cost of this warrant is set at 50 cents, the investor is paying 50 cents to buy a share at $1.80.

A difference of 20 cents exists between the ''exercise price'' of $1.80 and the share price of $2. This is the intrinsic value of the warrant.

A warrant with intrinsic value means the investor is buying the shares at less than their present value. In other words, our example shows the exercise price as being below that of the share price. This is called ''in the money''.

A warrant with an exercise price greater than the share price is ''out of the money''. At the same price, the warrant is ''at the money''.

In the above case where the warrant is in the money, the investor also had to pay 50 cents for the warrant. The difference between the price of the warrant, 50 cents, and the intrinsic value, 20 cents, is known as the ''premium''.

In our example, the premium is 30 cents. The share price has to rise by at least this much over the next six years to make the purchase of the warrant worthwhile. If it does not, the investor may as well have bought the share.

The length of time to maturity also affects the size of the premium. The longer to maturity, the higher the premium.

Likewise, the premium reduces as the warrant approaches the expiration date. On its expiration date, the warrant's only value is its intrinsic value, assuming it has one.

So what should the investor bear in mind when buying a warrant? To justify the warrant price, the share first has to rise by as least as much as the premium over the exercise period.

The return also has to compensate for the dividend lost by buying the warrant rather than the share, although against this loss the investor may set the interest made from lower capital outlay.

As with options, there are high risks. If the shares rise faster than expected, the warrant's intrinsic value will probably increase and the investor is well positioned to make a healthy profit. However, if the share price drops quickly, the intrinsic value will plummet and the losses can be great.

Before deciding on whether or not to use warrants, investors should talk with their broker. More information can be obtained from the Hongkong Futures Exchange on 842-9345.