Warrants: answers to all you daren't ask

COVERED warrant issues are springing up from almost every corner of the securities industry on just about any blue-chip stock that moves.

Or that is how it seems. There have been 11 issues in nine days of trade, and 15 issues in the year so far.

There are more than 30 covered warrants currently listed and traded on the exchange.

The total amount of stock this represents in underlying assets is estimated by some brokers to be worth more than $100 billion.

Three years ago, covered call warrants were unheard of. That changed when Cheung Kong and Hutchison Whampoa chairman Li Ka-shing launched one in the spring of 1991.

A call warrant, like an option, gives an investor the right to buy or sell an asset at a pre-determined price over a pre-determined period.


Straight warrants are in general issued by companies, often in addition to stock issues or as a bonus to shareholders. On conversion, these warrants will in general become new shares in the group.

The covered variety is issued by a third party on shares that are already trading. The backing, or cover, for the issue can either be in the form of the underlying shares in the issue or some other asset.

The covered warrant business in its initial phases - at the issue stage - is institutional. Merchant or investment banks place the warrants out to professional institutional clients.

Retail investors only get a chance to buy into the action when the warrant issue is listed on the exchange.


There are several yardsticks used to value these issues. Some are controversial, as many investment professionals have strongly differing views on their usefulness in determining value.

In Hong Kong, many investment professionals point out that trading of warrants in general is very much driven by sentiment, and that fundamentals are not always adhered to or useful in determining when to buy and sell.


However, premium, gearing and implied volatility are used to describe the key characteristics of issues at the time of the initial placement with institutions.

Premium on a call warrant is the warrant price plus the strike price minus the stock price - divided by the stock price. To convert this to a percentage you need to multiply the answer by 100.

S.G. Warburg Securities, in its warrants monthly bulletin, explains that this is the amount by which the cost of buying the stock through the warrant exceeds the current share price, expressed as a percentage of that share price.


''It is the amount by which the share price must rise for the warrant-holder to break even on expiry,'' says the broker.

Nominal gearing is the stock price divided by the warrant price. This gives the investor an impression of the level of exposure that has been obtained for the outlay on the warrant.

It is important to note that when calculating the premium and gearing, adjustments may have to be made for the number of shares per warrant.


At present it is quite common for an issue of warrants to be on the basis of 10 warrants per share, to cut the cost of participation and improve liquidity, especially in the secondary market.

In the early days, it was common for issues of warrants to be at the money. This meant that the strike price was the same as the share's closing price that day.

Therefore it is important not to get the strike price mixed up with the share price, as in yesterday's derivatives report on page 18, as it is quite common at present for issues to be made with strike prices in the money. That means the strike price is below the closing share price that day.

In the initial phase, Hong Kong issues of covered warrants have been issued on premiums of about 20 to 25 per cent, with gearing around 3.5 to 4.5 times.

Another yardstick is implied volatility. Covered warrant issuers are often reluctant to release this figure.

It is an important yardstick for options traders trying to compare the value of an individual option against a series.

According to the Peregrine guide on options, The Art of War, this is a judgment of the current volatility of a stock, based on the market price of the option and the underlying stock price.

A more exact definition is in Swiss Bank Corp's Dictionary of Financial Risk Management. It says implied volatility is the value of the price or rate of volatility variable that would equate current option price and fair value.

Alternatively, it is the value that buyers and sellers seem to accept when the market price of an option is determined.

In Hong Kong it is common to find issue implied volatility of about 40 to 45 per cent. This percentage indicates the likely percentage change in value of the investment during its life.