SGX Structured Warrants (Part 3)

This is the final part of a three-part series on structured warrants on the Singapore Exchange (SGX). The first two articles can be found here and here. This week, we focus on key warrants terms that investors must know, the specific methods of warrant investing and key investment risks for warrants.

[Photo: Ed100]

Only for CashBench Group Members Those who join CashBench on Yahoo! Groups will immediately receive this entire three-part series on warrants in a single PDF report for easy reference, wherever you are. What's more, membership is free and you’ll also receive updates once a week or less often on new analysis, forecasts and news from CashBench! To join CashBench now, just provide your email address below.

Key Warrant Terms:

If you have found a good reason to invest in warrants by now, it’s time to go through the key warrant terms that you will encounter when investing. Among these terms, the more important ones are the warrant name format, and conversion ratio. These have been placed right at the top of this section. The remaining terms are more technical in nature and are also included for your reference.

Warrant Name Format

First, let’s start with the name of a warrant on the SGX. Every listed warrant uses a name that contains some useful information to the investor. It follows this format:

[Underlying]	[Ex. Price]	[Issuer]	[Ex. Style]	[Call or Put]	[Expiry Date]
STI	3000	SGA	e	CW	091029

An example of a warrant name is STI 3000SGAeCW091029. The name tells us that the underlying asset of this warrant is the STI index with an exercise price of 3000. Since the STI is an index, 3000 refers to the index level and not a dollar amount. For warrants on a single underlying stock, the warrant name does not include the exercise price. Next, the third-party issuer is SGA, or Societe Generale. Other common issuers are DB for Deutsche Bank and MBL for Macquarie Bank. The “e” tells us the exercise style is European. CW represents a Call Warrant, whereas PW means a Put Warrant. The last 6 digits is the expiry date. For this example, 091029 refers to an expiry date of 29 Oct 2009. The 6 digits therefore uses the YYMMDD date format.

Despite the useful information contained within the warrant name, these are not sufficient to a potential investor. There are other terms you may encounter and they are covered in the rest of this section.

Conversion Ratio

The conversion ratio for a warrant is another term that every warrant investor must know. When a warrant investor exercises the right to buy or sell the underlying asset of a warrant, the conversion ratio determines the number of warrants needed to buy or sell each underlying asset. For example, a 1-to-1 conversion ratio for a DBS call warrant means 1 warrant can be used to buy 1 underlying DBS share. If the ratio is 10-to-1, 10 warrants is needed to buy 1 underlying DBS share, and so on.

3 States of Every Warrant

Next, we look at the 3 possible states of a warrant. Every warrant is always in one of 3 states, In-The-Money (ITM), Out-of-The-Money (OTM), or At-The-Money (ATM). These are just short forms to describe if the warrant has any exercise value.

• In-The-Money (ITM) occurs when the warrant has exercise value. For a call warrant, the current underlying asset price must be higher than its exercise price (Example: Call warrant with exercise price of $15 and the current underlying is $20). For a put warrant, the current underlying price must be lower than its exercise price.
• Out-of-The-Money (OTM) is the reverse of ITM where a warrant does not currently has any exercise value. We do not have any right to exercise a warrant in an OTM state, and if it remains such as, the warrant expires worthless.
• At-The-Money (ATM) occurs when the current underlying asset price of a call or put warrant is exactly equal to its exercise price (Example: Call warrant with an exercise price of $15, and the current underlying price is $15 too).

Intrinsic Value & Time Value

Intrinsic Value is just another name for Exercise Value … equal to the gain we get if we can exercise the warrant immediately…

Next, the price of every warrant can always be broken down into 2 components, intrinsic value or time value:

• A warrant has intrinsic value only when it is in the ITM state. Therefore, intrinsic value is just another name for exercise value. Intrinsic value is equal to the gain we get if we can exercise the warrant immediately. (Example: Call warrant with exercise price of $15 and underlying share price is now $20. The intrinsic value is then calculated as $20 - $15 = $5).
• All warrants also have a time value. This value is not as simple to calculate. Investors just need to know that the time value of a warrant quickly decreases to zero as its expiry date approaches. This is also the reason why investors do not usually invest in warrants that will expire soon because the price of an expiring warrant is more likely to drop due to a rapidly decreasing time value.

Together, the intrinsic value and time value will equal the price of a warrant. This is the price that an investor will need to pay to buy a warrant. As a warrant will always has some time value left before its expiry date, the price of a warrant is always positive.

Premium

We have just a few more terms to cover. Premium for warrants refer to the percentage price change in the underlying asset needed to break even. The calculation of premium assumes we will hold the warrant until expiry. For example, a premium of 10% for a DBS call warrant means the share price of DBS must increase by 10% for an investor to cover the cost of buying the warrant. Any further increase means the investor has made a profit.

Some investors choose warrants based on its premium, but this is not usually a good idea because premiums do not determine warrant prices. Instead, investors should use the major factors described in the second article of this series (E.g. Underlying Asset Price, Implied Volatility, etc) to choose which warrants to invest in.

Gearing, Effective Gearing, & Delta

... a 5x Effective Gearing means a 10% increase in DBS Shares will result in a 50% increase in the DBS warrant price.

Gearing and Effective Gearing are measures used to determine the leverage effect of buying a warrant compared to buying the underlying asset. Effective Gearing is the more accurate measure, calculated using the Delta and Gearing of the warrant. There is however no need to know the specific calculation.

What’s important here is to interpret Effective Gearing. For example, if a warrant has an Effective Gearing of 5 times, the warrant price will theoretically change 5 times more than the underlying asset. Using the DBS shares example again, a 5x Effective Gearing means a 10% increase in DBS shares will result in a 50% increase in the DBS warrant price.

However, please note that the Effective Gearing of a warrant is not constant and changes as the warrant moves among the 3 states (OTM, ATM & ITM). For this reason, Effective Gearing is best used as an approximate reference and investors may want to monitor this regularly for changes.

How to invest in Warrants:

There are 2 basic approaches to investing in warrants, buy and hold, or sell-before-expiry.

If you have read this far, you must be eager to start investing in warrants. We are almost ready for real action! There are 2 basic approaches to investing in warrants: buy and hold, or sell-before-expiry.

Buy & Hold Approach

This approach is not usually recommended, and the reasoning is simple. It is already a tough job to forecast whether the underlying asset price of a warrant will increase or decrease. What’s more, there are other factors that influence warrant prices as CashBench has already explained. If we adopt a Buy & Hold approach, how can we be sure that all these factors are working in our favour on a single day – the day that the warrant expires?

However, if you do feel extremely confident of your forecast, do take note of the following points:

• Auto-Exercise / Exercise Notice: Don’t assume that a warrant that has exercise value will be automatically exercised on your behalf. It often is, but if it isn’t, you must submit an exercise notice. Details will be available with the issuer of the warrant.
• Cash / Physical Settlement: You may have an option to either receive cash upon exercising your warrant, or to get the underlying asset transferred to your Central Depository (CDP) account. Again, check with the warrant issuer. Do note that all warrants on stock indices will be cash-settled because it’ll be too messy to distribute the component stocks of the index to you.
• Settlement Price: The price that is used to calculate any gains for you is usually not based on the closing price of the underlying asset on the expiry date of the warrant. This will be specified by the warrant issuer in advance, and is typically based on an average of the last 5 closing prices of the underlying before expiry. This helps to avoid deliberate price manipulations by speculators. However, warrants issued for a stock index (e.g. STI) will usually be based on the closing index level on expiry date as stock indices are less subject to manipulations.
• Settlement Calculation: To determine how much gain you are entitled to when exercising a warrant, use this formula: (Settlement Price – Exercise Price) ÷ Conversion Ratio. Let’s look at a quick example. We have a call warrant on DBS with a settlement price of $20, an exercise price of $15 and a conversion ratio of 10. The gain per warrant = ($20 - $15) ÷ 10 = $0.50.

Sell-Before-Expiry Approach

All warrant investors … must know that they cannot buy or sell a warrant right up to its expiry date.

The second approach to warrant investing is Sell-Before-Expiry. Compared to the Buy & Hold approach, this approach is more flexible and similar to stock investing. Instead of waiting for the warrant to expire, we buy a warrant and regularly monitor all the major factors that affect its price. Recall that these factors include the price of the underlying asset, implied volatility, and time-to-expiry. The last major factor is the exercise price, but this does not need to be monitored because it remains constant. Instead, we select a warrant with an appropriate exercise price right at the start of investment.

Once the first 2 factors move in our favour considerably, we will sell the warrant immediately and not wait for it to expire. Our gain will simply be the price we sold the warrant minus the price we paid for it initially. Of course, we may also make a loss. Since this approach is so similar to stock investments, many warrant investors use this approach by default.

However, all warrant investors that use this approach must know that they cannot buy or sell a warrant right up to its expiry date. For most warrants, the last trading day is the 5th business day before expiry. If in doubt, check with the warrant issuer!

What are the investment risks:

The maximum loss for warrants is much more likely to occur than stocks because of the limited life of all warrants.

This series on investing in SGX structured warrants is almost complete. You now have almost all the key knowledge required to invest in warrants. We end with the most important section of all: what are the risks of warrants investing?

We already know by now that warrants depend on quite a lot of factors to work properly and there are therefore many risks to warrants investing. Some of the major risks include the following:

• Liquidity: You may not always be able to buy or sell a warrant whenever you want to. This is because each warrant has a specified maximum issue size. When there is very strong demand for a particular warrant, the warrant issuer may not have enough remaining warrants to sell to you. This may result in unpredictable and volatile warrant prices.
• Currency: Similar to stocks, any warrants that are quoted in a foreign currency is subject to currency fluctuations. These fluctuations may be in your favour or against you.
• Issuer: Structured warrants are usually issued by large and stable banks. However, we know that banks can get into trouble too. If the issuing bank fails or goes bankrupt, our warrants may become worthless even if the underlying asset price moved in our favour.
• Underlying Asset: Just like any bank, the underlying asset of a warrant can get into trouble too. If the underlying asset is a company and it goes bankrupt, or its shares is suspended or delisted, our warrants may become worthless. Check the warrant terms & conditions for the specific actions that the warrant issuer will do in these scenarios.
• Maximum Loss: The maximum loss when investing in warrants is the initial price we paid for the warrants. This is also true for stocks. However, the maximum loss for warrants is much more likely to occur than stocks because of the limited life of all warrants. In just a few months, all money invested in a warrant can go down the drain, never to come back.

You now know all the key features of warrants and every other important aspect needed to start investing. The warrant websites maintained by the major warrant issuers are important references from here onwards. These include Societe Generale, Deutsche Bank and Macquarie Bank. These websites provide information on warrants currently available and related data such as underlying asset price, implied volatility and exercise price.

If you have found this series useful, share your comments and do keep up with the latest analysis, forecasts and news on CashBench. To receive updates or get this series in a single PDF report now, join CashBench on Yahoo! Groups by providing your email address below.

Lowest CFA Level 3 Exam Pass Rate

This is one of those very rare occasions where CashBench focus more on my personal experience rather than analyse news or give out investment tips. Today, Channel NewsAsia has an article under Singapore News  on the 45% pass rate for all CFA candidates. This is across all three CFA levels around the globe, based on results of the recent Jun 2009 examinations. In the Asia Pacific region, the passing rate was even lower at 42%. Right here in Singapore, 7,800 signed up for one of the strength-draining 6-hour exams this year. In fact, the results for levels 2 and 3 were only released yesterday, and represents an important milestone for CashBench.

First, the release of the results meant that CashBench has passed the third and final level of the CFA examinations. Each of the 3 levels were so rigorous that only a very well-prepared participant can ever dream of passing. Of all the investment related programmes or certifications out there, the CFA charter holder examinations is often regarded as the most difficult and rigorous. Currently, Singapore only has 2,343 CFA chart holders who have passed all exams and accumulated the required professional experience. Hence, it is often a pre-requisite and/or preferred qualification for many senior investment related positions.

Second, this year’s CFA level 3 examination was also significant in another way.  Usually, most participants at CFA level 3 will already be very well prepared since they have gone through 2 rigorous levels beforehand. However, since the CFA examinations started in 1963, the global passing rate for level 3 participants this year is the lowest ever! To be part of the 49% who have passed the level 3 examination for 2009 is therefore even more special personally.

CashBench is glad to have gone through this journey nevertheless as participating in both a top-ranked MBA programme as well as the CFA program simultaneously meant that CashBench is much more well-versed across business and finance, particularly in investment-related sub-fields. For those who would like some extra ad-hoc help for their own CFA examinations, CashBench has the CFA Ace and CFA Ace Premium service to answer CFA related questions that you may have while preparing for the examinations.

Finally, and most importantly, CashBench wants to especially thank two friends who helped to kick-start my CFA journey. For the first friend, the act was simple but crucial. This friend owned a CFA-approved calculator and very generously gave away the calculator to CashBench 2 years ago. There are in fact only 2 calculator models approved for use in CFA examinations and this simple act meant that CashBench need not buy a new one. The calculator is still working :) The help from a second friend was more indirect but also crucial. When CashBench has just started MBA classes, one of his classmates started sharing on the CFA program and the classmate’s own experience in pursuing the program. Without this generous and unreserved sharing, CashBench may not have started and passed the CFA examinations so soon. To both friends, CashBench says a very big thank you!

Practise Investing Without Risk

CashBench once asked a friend, “how much are you willing to lose for an initial investment of $5000?” This friend replied “I'm not a risk taker. $50?”. If you are like this friend, but wants to enjoy the thrill of forecasting the future, what can you do? CashBench suggests a safe option. 

[Photo: Sreejith K]

There are many of us who very much prefer to take little or no risk with our own money. Keeping spare cash in the bank is the preferred option, as the thought of an investment falling in value is simply unacceptable. There is nothing wrong with feeling this way. Yesterday, the Shanghai Composite index fell more than 5%. My friend, who can only lose S$50,  will probably get a shock if he has invested in China-linked unit trusts or exchange-traded funds (ETFs).

Some of us may simply not be ready for taking risks. Others do not have sufficient spare cash to put into risky  investments for a wide variety of reasons. However, it would often be beneficial to practise the forecasting of future events or the direction of markets. As the saying goes, “practice makes perfect”. If you can forecast well, you may be more willing to invest, knowing you’ll be more likely to have a profitable investment.

Make use of “wisdom of the crowds” principle to predict future events … what the majority believes to be true, will usually come true.

So what can we do to practise in a safe and riskless way? CashBench came across the CFO Prediction Market recently and suggests this as one possible avenue to practise your forecasting & investing skills without risking any money. The real purpose of the CFO Prediction Market is to make use of "wisdom of the crowds” principle to predict future events. This is based on the belief that what the majority believes to be true, will usually come true.

The CFO Prediction Market allows us to place our own forecast of the future and also see what’s the current aggregate forecasts of everyone else. For the Asian or Singapore investor, some relevant forecasts we can place include the closing price of the S&P 500 stock index, the quarter that the US economy stop falling, or even the date where Boeing carries out its first test flight of the 787 Dreamliner aeroplane. Participants of the CFO Prediction Market can forecast a range for any of these events and more, with an initial “cash balance” of $20,000. For example, a participation may use $1000 to forecast that the first test flight of the Dreamliner will occur between Dec 2009 to Jun 2010. A smaller date range will allow you to “gain” more cash if your prediction is correct.

As you can see, forecasting and investing goes hand in hand. The best way to make use of the CFO Prediction Market is to research on each event, and formulate your forecast based on that. If you are confident of your forecast, you can of course use a larger portion of your cash balance for that forecast. However, without adequate research backing up our forecasts, we are just placing bets without any basis.

To practise your forecasting and investing skills, visit the CFO Prediction Market and create an anonymous profile.

Note: CashBench is not affiliated or commissioned by the CFO Prediction Market to publish this article and did not receive incentives or compensation of any kind from CFO Prediction Market.

Get CashBench Updates via Email

[Photo: Pandemia]

For those who wants to be updated via email on new analysis, forecasts and news from CashBench, simply join the CashBench group on Yahoo today. It’s free and group members will receive email updates once a week or less often. This will ensure every update from CashBench will be useful, and you are not overloaded with emails too.

 

In addition, CashBench respects your privacy and will not share your particulars with group members or anybody else. You can also easily subscribe or unsubscribe at any time. Upon joining, new members will receive a sample update immediately to get a good idea how CashBench email updates look like.

 

Besides receiving updates, CashBench group members on Yahoo will also be able to access new tools and PDF reports from time to time. Right now, new group members will immediately receive two gifts: the CashBench Excel Tool to calculate fees & taxes payable for investments, and a PDF report on how to invest in warrants. To sign up for email updates, just send a blank email to cashbench-subscribe@yahoogroups.com or provide your email address below.

Why is “dark pool” good for SGX?

The Straits Times Money section today has the frontpage headline “SGX wades into ‘dark pools’”. However, to the average investor, this sounds just like another venture by the Singapore Exchange (SGX) with no major significance. CashBench points out its relevance to SGX and you.

[Photo: D H Wright]

If you’re wondering what are “dark pools” anyway, these are platforms set up to allow very large investors to buy or sell shares anonymously. Think of dark pools as off-market stock exchanges. These large investors are also not men on the street like us, but invest on behalf of large companies and even governments. Hence they’re usually referred to as “institutional investors”.

… institutional investors … prefer to buy and sell anonymously without affecting market prices.

Dark pools are a great way for institutional investors to adjust their investment portfolio because of the anonymity provided. When institutional investors buy or sell shares, they often move markets because of their large share holdings. However, news can easily leak out and make buying or selling much more expensive for them. Just a hypothetical example, if we learnt that Temasek Holdings is going to sell its 40% stake in a company within the next 3 days, what will many investors do? Follow Temasek and sell! Since the share price of this company will likely drop into the valley, Temasek will get lesser cash for its stake as it need to keep selling over the next 3 days even though the company’s share price continues to drop. Hence, institutional investors such as Temasek prefer to buy and sell anonymously without affecting market prices.

If more and more institutional investors go for dark pools, SGX will … lose more and more of its trading and clearing fees …

So, what is the relevance to SGX? Plenty. Dark pools actually compete with stock exchanges like SGX for business. If more and more institutional investors go for dark pools, SGX will progressively lose more and more of its trading and clearing fees for every buy/sell trade. Dark pools are popular in the US and Europe, and Asia will follow suit in due time. With lower revenues and lower profits, it is unlikely for SGX to repeat its performance of an annualised return of 36% for investors over the past 5 years as pointed out by CashBench in the bluest chips of Singapore article.

If you can’t beat them, join them. It’s brilliant for SGX to “wade” into dark pools now while Asia is only starting to get serious about these platforms. And why just limit ourselves to Singapore companies? SGX’s joint venture with Chi-X will cover companies listed on Australia, Hong Kong and Japan too. As dark pools get popular in Asia, this new source of income from dark pools will substitute any potential drop in revenues in trading/clearing fees. And for investors, SGX will be a more attractive investment option than without this dark pool venture.

Options vs. Warrants

The Sunday Times published the article “Options trading a better bet than stocks?” on 8 Aug 2009. CashBench readers may be surprised to read that options sound very much like warrants.  Here, CashBench takes the opportunity to compare warrants and options on the Singapore Exchange (SGX).

[Photo: Ed100]

First, readers will note that CashBench has an on-going three-part series on SGX structured warrants that discusses the key features of warrants and every important aspect that an investor must know before investing in warrants. The first-part of this series can be found here.

The Sunday Times article was indeed a good introduction to options, however, it did not compare options to warrants, which is appropriate as both share many similar characteristics. CashBench will now point out the three key differences between options and warrants to complement our current series on warrants:

1. Options can be “written”

Recall that warrants come in two types, Call warrants and Put warrants. Investors typically buy a Call warrant if they expect the underlying asset price to rise. Alternatively, we can buy a Put warrant if we expect the underlying asset price to fall.

These two basic types are also available in options. We can therefore buy a Call option or a Put option as well. However, option investors can also “write” an option for a fixed price. For comparison, writing an option is similar to acting like a warrant issuer that issues a new Call or Put warrant. As you can imagine, this increases the risk of options investing. For an explanation, see the second major difference between options and warrants below.

2. Options can result in unlimited loss

In the event that the option can be exercised … our poor investor must cough up the money to pay the profits of the option buyer

A warrant buyer’s maximum loss is always limited to the amount he initially paid for the warrants, be it Call warrants or Put warrants. This is also the case for those who buy options.

However, investors who choose to write options can face an unlimited loss. This is because the only gain from writing an option is the fixed price the investor receives. Once “written”, this option is sold to anybody who wants to buy a call or put option. In the event that the option can be exercised (just like warrants), our poor investor must cough up the money to pay the profits of the option buyer. For this reason, all option writers are subject to the risk of an unlimited loss.

3. Differences in underlying asset

Warrant issuers can choose from a wide range of underlying assets that include major stocks listed on the Singapore Exchange, as well as major stock indices from other countries.

Options on the Singapore Exchange are currently available for the Nikkei 225 Index, MSCI Taiwan Index, MSCI Singapore Index, Eurodollar and Japanese Government Bonds. As you can see, there is not a lot of overlap between the underlying assets of options and warrants. In the Singapore context, warrants generally have a larger selection of underlying assets to choose from. Option investors will also need to open a trading account specific to options/futures before they can start investing in options.

Readers should now have a good idea of the differences between options and warrants. Do look out for the last part of CashBench’s three-part series on warrants too. The first two parts can be found here and here. If you would like to receive a PDF report of this entire series before they are published on CashBench, join the CashBench group on Yahoo! to get the report immediately. Group members will also receive email updates on the latest analysis, forecasts and news from CashBench. Membership is free too, just provide your email address below.

Changes to Financial Reports of SGX Firms

This post is based on the Business Times article “A tale of two bottom lines” published on 4 Aug 2009. The focus is on the changes in the financial statements reported by Singapore-listed companies that investors must know. Here, CashBench provides a summary of the article, and includes additional supplementary information to help every investor understand these changes.

 
[Photo: Ramp Creative]

Due to changes made to the Financial Reporting Standard 1 (FRS 1) effective 1 Jan 2009, Singapore-listed companies will change or has changed the presentation of their financial statements. For investors, the key is to understand that the balance sheet is now the statement of financial position, the income statement is renamed as the statement of comprehensive income, and the cash flow statement is now the statement of cash flows.

Companies can choose to report a single statement of comprehensive income, or show two separate statements.

In particular, companies can choose to report a single statement of comprehensive income, or show two separate statements. The second option means companies will include both an income statement and a statement of comprehensive income when reporting company results.

What’s more, additional items reported under comprehensive income will include any changes in equity that are not due to actions by the owners of the company. Some examples include changes in the fair-value of assets meant for sale, gains or losses through hedging, and the translation of foreign currencies back into the reported currency. All these scenarios can affect earnings. Additional explanation for these as follows.

The fair-value (i.e. market value) of assets that are meant to be sold over the short-term can rise or fall in value. Many companies used to report such value changes in the statement of changes in equity, and not in the income statement. With the change in FRS 1, such gains or losses must now be reported directly in the statement of comprehensive income.

Hedging is the process where companies manage risk, usually through the buying or selling of derivative products. An example is the use of futures to manage price risk. A well-known example is Singapore Airlines, who regularly hedges against prices of jet fuel increasing in the future. However, hedging may result in losses if the company made a wrong assessment on the direction of market prices. These gains or losses will now be reported in the statement of comprehensive income too.

Translation of foreign currencies back into the reported currency affect all companies that has operations overseas, or imports & exports to overseas markets. Since a portion of the cash earned is not in Singapore dollars, these must be “translated” back into Singapore dollars for consolidation into the financial statements. Again, companies may gain or lose, depending on the strength of the Singapore dollar. Such gains or losses are also reported in the statement of comprehensive income now.

Overall, these changes means that every investor who regularly tracks the quarterly results or annual reports of Singapore-listed companies will have a better idea of the actual financial situation within these companies.

SGX Structured Warrants (Part 2)

This is the second of a three-part series on structured warrants on the Singapore Exchange (SGX). The first article can be found here. This week, we focus on the reasons for investing in warrants and what determines and moves the price of a warrant.

[Photo: Ed100]

Only for CashBench Group Members Those who join CashBench on Yahoo! Groups will immediately receive this entire three-part series on warrants in a single PDF report for easy reference, wherever you are. What's more, membership is free and you’ll also receive updates once a week or less often on new analysis, forecasts and news from CashBench! To join CashBench now, just provide your email address below.

Why Invest in Warrants:

We should only buy a product if it can serve some useful purpose. Likewise for warrants, there are specific scenarios where an investment will be suitable. The two usual scenarios either require a short-term forecast, or a need to protect an existing investment.

Reliable Short-Term Forecast Available

The key is to have a good forecast of the short-term direction of the underlying asset before investing in any warrants.

Since warrants expire quite quickly, they are good investments only if we are fairly certain of the short-term performance of a stock index or listed company in Singapore. For example, if we expect the STI index to drop by 10% over the next 3 months, we can buy a STI put warrant to profit from this forecast. This is because the prices of put warrants usually increase if their underlying assets’ price decreases. In addition, we already know that the prices of warrants will usually change much more than the underlying asset. Therefore, a 10% drop in the STI may increase the price of a STI put warrant by more than 10%, let’s say 40%!

However, if we feel that the price of the underlying asset will increase over the short-term, we should consider buying a call warrant instead. Any price increase in the underlying asset will usually result in a larger increase in the price of a call warrant too.

In both cases, the key is to have a good forecast of the short-term direction of the underlying asset before investing in any warrants.

Protecting an Existing Investment

The other reason for buying warrants is to protect an existing investment. This is usually done by buying put warrants only. Let’s go through a quick example using DBS shares again. If we have an existing investment in DBS shares and is worried that the share price of DBS may drop over the next 3 months, we can buy put warrants to protect our investment in DBS. If the price we paid for these DBS shares was $10 per share, and we do not want to lose more than $1 per share, what can we do?

This concept is very similar to buying insurance: pay an “insurance fee” to get protection from a drop in the … share price.

Simple, just buy sufficient DBS put warrants at an exercise price of $9. If DBS shares really do drop below $9, the gain from the warrants will help to offset the loss in our existing investment in DBS shares. This concept is very similar to buying insurance: pay an “insurance fee” to get protection from a drop in the DBS share price. The price you paid for the warrants is the “insurance fee” and represents the cost of this protection. This cost is not high too, as you’ll recall that warrants are usually much cheaper to buy than the underlying. What’s more, we can still profit from any increase in our DBS shares with this arrangement. So, if DBS price falls, we are protected. If DBS price increases, we still profit. Not too bad!

Less valid reason

Even though warrants are cheaper to buy and therefore, allow you to spread out your spare cash by buying many more warrants on different companies or stock indices, do not overstretch yourself. The typical portfolio of an investor should not contain a majority of warrants, because investing by its very nature is a long-term process. If you are investing only in short-term products, you are exposing yourself to significant risks. Therefore, freeing up spare cash by converting all existing stock investments to warrants is usually not a good idea.

What moves Warrant Prices:

There are all together 6 factors that determine the prices of warrants: Underlying Asset Price, Implied Volatility, Time to Expiry, Exercise Price …

Every warrant investor must know the factors that determine warrant prices. Otherwise, we may be surprised why the price of a warrant is not moving in a direction we have expected. There are all together 6 factors that determine the prices of warrants: Underlying Asset Price, Implied Volatility, Time to Expiry, Exercise Price, Interest Rates and Dividends.

To determine the actual price of a warrant at any time, financial models are used by each third-party bank to calculate the buy/sell prices quoted on SGX using all 6 factors. However, the first 4 factors are the major drivers of a warrant’s price. In addition, the supply and demand for warrants can also affect prices. Because so many factors help to determine warrant prices, we must minimally look at the 4 major factors before understanding how prices will move. Fortunately, there is no need to calculate any numbers at all as these information are generally made available by warrant issuers.

Let’s now focus on the 4 major factors. Bear in mind the use of “good” and “bad” in the following explanations. “Good” means the warrant price should increase. “Bad” means the warrant price should decrease.

Underlying Asset Price

An increase in the underlying asset price is good for a call warrant but bad for a put warrant.

Previous examples in this series have already covered this factor. We should now know that an increase in the underlying asset price is good for a call warrant but bad for a put warrant.

Let’s look at a quick example for a DBS put warrant with an exercise price of $15. As the underlying DBS share price increases, it becomes less and less likely that we can exercise the put warrant to sell DBS. Recall that the DBS share price must fall to $15 or below before we can exercise a put warrant. Let’s say the current DBS shares have increased steadily from $20 to $25. If this happens, our DBS put warrant’s price will most likely decrease considerably.

Since the underlying asset price is a major factor that determines the movement of a warrant’s price, we must monitor it regularly for any warrants we invest in.

Implied Volatility

A higher volatility in the underlying asset is good for both call and put warrants.

Volatility refers to how stable are the prices of an asset. For example, a very volatile share price may jump wildly from $1 to $5 and back to $3 within a short period. The third-party banks that issue warrants calculate a special form of volatility that is referred to as Implied Volatility. The details of this calculation is not important.

What investors do need to know is this: a higher volatility in the underlying asset is good for both call and put warrants. This is because there is a higher likelihood that the underlying asset price will move in our favour. On the other hand, a lower volatility has the opposite effect and pulls down the price of a warrant.

In addition, the volatility of any underlying asset’s price is not constant, and can change quickly. Therefore, it is again important to monitor volatility changes to determine its influence on the price of a warrant.

Time to Expiry

The price of a warrant can drop quite quickly as its expiry date near.

As the time-to-expiry decreases, this is bad for any warrants generally. The reasoning is simple. As the expiry date approaches, there is less time for the underlying asset’s price to move in our favour. The price of a warrant can drop quite quickly as its expiry date nears. For this reason, many investors do not bother to buy warrants that will expire within 2 weeks. This is especially the case for warrants where the underlying asset price is still far away from the required exercise price. With such a short time-to-expiry, there is a much higher likelihood of losing the money spent in buying these expiring warrants.

Exercise Price

High exercise prices are always bad for call warrants but good for put warrants.

The exercise price is pre-determined for each warrant and we cannot change it, but we should know how it affects warrant prices. High exercise prices are always bad for call warrants but very good for put warrants.

For example, just imagine a DBS call warrant that has an exercise price of $100. It’s almost impossible for DBS’s share price to increase to $100 within a few months, hence, this call warrant price will be very low and is unlikely to move higher.

4 Factors All Together

The 4 factors above should be used collectively by an investor to understand why a warrant’s price is increasing or decreasing. Forecasts of the first 2 factors will also allow investors to estimate how the price of a warrant will move in the future.

In the final part of this series on SGX structured warrants, we’ll cover the remaining concerns of every investor: the key terms that investors will come across, how to actually invest in warrants, and the specific risks of these investments.