on March 21, 2017 Trading & Investing

5 things you might not know about warrants

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I must confess that I’m writing this blog from a position of ignorance. Contrary to the adage, it’s not bliss; it makes me uncomfortable to know there’s an entire category of investment vehicle about which I have little knowledge or understanding. A better title might be ‘5 things I don’t know about warrants’ – however, a quick straw poll taken at a lunch last week suggested that I’m not alone. So, while some readers may quite fairly yawn at this point, if like me, you haven’t delved much into the world of warrants but would like to understand more, read on.

5 things you might not know about warrants

1. There are only a handful of issuers

Warrants are financial instruments issued by banks and other institutions and are traded on ASX. I knew two of these three facts, however I, incorrectly, thought that companies issued their own warrants – wrong. There are eight issuers in Australia:

Issuers of warrants
CitiWarrants (Citigroup)
CBA
Macquarie Bank
RBS Alternative Investments (Aust)
Royal Bank of Scotland
UBS AG
UBS Investments Australia
Westpac

 

2. Warrants are a form of derivative

Derivative (noun)

‘an arrangement or product (such as a future, option, or warrant) whose value derives from and is dependent on the value of an underlying asset, such as a commodity, currency, or security’

Like futures and options, warrants derive their value from an underlying instrument. In the same way, some warrants give holders the right to buy, or the right to sell, the underlying instrument to the warrant issuer for a specific price, according to the terms of issue.

Warrants may be issued over a range of securities, including:

  • shares
  • a basket of securities
  • Exchange Traded Funds (ETFs)
  • a share price index
  • debt instruments
  • currencies

3. Warrants are not homogenous

Since their ASX debut in 1991, warrants have evolved over time…so much so, that according to the ASX, it is difficult to define characteristics pertaining to all warrants. Despite this, warrants generally fall into one of two buckets – trading warrants or investment warrants. Just to confuse things, some might straddle both buckets.

The following table summarises the key differences between the two styles:

 
Investment Warrants
Trading Warrants
Why are they used?
Borrow to invest in shares and increase exposure to potential capital growth, dividends and franking credits
Trade the rise or fall of shares, indices, commodities and currencies
Features
Longer dated and less frequently traded, lower risk/return profile and tend to have a higher initial outlay required
Frequently traded and shorter dates, higher risk/return profile
Investment timeframe
Medium to long term
Short term
Key benefits
Leverage and no margin calls
Leverage and no margin calls
Key investment risks
Leverage can magnify losses
Leverage can magnify losses
Used by
SMSFs and individual investors
SMSFs and individual investors
Examples
Endowments and structured investment products
Equity warrants, index warrants, barrier warrants and MINI warrants

Source: ASX

Instalment warrants have a foot in both camps – some investors hold instalments for trading purposes, while others hold them as a long-term investment.

To make the investor’s life more complicated, warrants do not have standardised terms. In other words, it’s important to read the applicable disclosure document, as each warrant issuer may vary the terms, although they are limited by the constraints of the ASX Operating Rules and the law.

4. The reasons people invest in warrants

Warrants are traded on the ASX and settlement of trades occurs through CHESS. So are many other securities. The big question is, why warrants?

Leverage

Like with any derivative, the leverage provided by a warrant will magnify gains…and losses. Warrants provide exposure to an underlying asset for a mere portion of the price; a small change increase in this asset’s value can result in a larger increase in the value of the warrant.

Loss limitation

Leverage can be a double-edged sword – great if the underlying asset appreciates in value, frightening if its value moves in the wrong direction. However, one of the benefits that makes warrants interesting is this fact:

The maximum amount a warrant holder can lose is the amount they paid for the warrant.

A warrant is limited recourse – the most an investor puts at risk is the initial purchase price of the warrant – a far cry from the potentially bottomless pit when options and futures don’t go your way.

No margin calls

Another side effect of leverage going wrong is the margin call. However, because warrants are limited recourse, there are no margin calls. This makes warrants a lot more attractive to SMSFs – a fund balance could be adversely impacted by serious margin calls.

Diversification

Warrants are a cost-effective way to diversify a portfolio. Warrants over an index, an ETF or a basket of securities provides exposure to price movements in a market or sector without having to buy a huge number of securities.

There are international index warrants and international equity warrants as well, to ensure portfolio diversification extends beyond Australian shores.

5. The risks associated with using warrants

All investment carries some degree of risk, and warrants are no exception.

Leverage

The downside to leverage; while it can magnify gains, it can also increase losses. Although these are limited to the value of the warrant, it’s still a loss.

Liquidity risk

The risk that there may not be a market to sell warrants for a reasonable price; this may be the result of insufficient purchasers, or an unwillingness to pay the asking price. The liquidity of the underlying instrument can also affect the liquidity of the warrant.

Limited life

Warrants come with an expiry date, after which they cannot be exercised. Once expired, there’s no opportunity to benefit. If an investor holds a warrant until expiry and doesn’t exercise it, they may receive a reduced payment – or nothing at all!

Issuer risk

The risk that the issuer will not meet its obligations under the warrant, which is an unsecured obligation not guaranteed by the ASX or other parties.

There are so many different types of warrant, each with its own set of benefits and risks, unique product features and an individual raison d'être. As with all investments, it pays to do some research, get expert advice and read the fine print.


General Advice Warning
The information provided in this post is general information only and is not designed for the purpose of providing personal, financial or investment advice. Any examples are presented for illustration purposes and past performance is not a reliable indicator of future performance. The information provided does not take into account your particular investment objectives, financial situation or investment needs. 

Tracey Franks (OM blogger)

Tracey Franks is an experienced freelance writer, communicator and marketer. She has worked in financial services for over 20 years, for businesses spanning stockbroking, funds management, research and consulting, as well as financial planning. When not writing about finance-related topics, Tracey is working on her first novel.