SUPPLIER AND TECHNOFIN®

The Covered Warrant Converts –the market on the rise

Covered warrants have offered investors the ability to trade a leveraged investment, with unlimited profit potential and with a limited down side known and capped at outset and no stamp duty. What’s more, they could be easily traded through the trader’s existing stockbroker.

The traders have remained a significant driver of the daily volume but things are beginning to change.  The market has grown rapidly over the last couple of years, like in Europe, where there is a long established market.

Many long term and more risk sensitive investors now regard covered warrants and their related instruments as an essential part of their investment portfolio.

So how are these new covered warrant converts using this product within their portfolios?  There are a number of different investment strategies available to investors.

Product Combiners

By combining covered warrants with other retail investment products investors are now able to design their own investment products that previously they would have had to have bought ‘off the shelf’ from an established financial service provider. 

The advantage of building rather than buying is the same as in all walks of life, it can be cheaper, to your specification and you have greater flexibility in the management and term of the investment.

Capital Guarantee products, well known in the UK marketplace, are just one example of the types of investment product combiners are now creating.

Capital Guarantee products allow investors the ability to secure a proportion of their capital whilst also benefiting from an ‘equity-linked’ element which enables the investor to participate in a percentage of any increase of a specified equity index.

These products are created by combining a zero coupon bond with a call option on an equity index. The zero coupon bond pays no income during its life but rather is redeemed at expiry for 100.

The return from a zero coupon bond is derived from the fact that it is issued at a discount to 100 to reflect the interest that is foregone by the holder.

It is this discount that is used to purchase the call options (or warrants in this case) on the equity index. Let’s take an example, assuming that a one-year zero coupon bond in sterling can be purchased at 95% and will pay out 100% 1 year hence.

The 5% discount is then used to buy one year maturity at-the-money call warrants on the FTSE 100. Let’s assume that a Sep-05 FTSE call warrant with a strike of 4600 costs 6.5% - the investor has 5% to spend on the warrants and therefore is able to effectively purchase 77% of the call warrant (5 divided by 6.5).

This 77% is known as the participation rate and it signifies the fact that the investor will receive 77% of any rises in the FTSE 100 index over the coming year. If the index falls then the warrant will expire worthless.

Either way the investor knows that the zero coupon will pay out 100% in 1 year so the worst case scenario is that the investor gets their original investment back.

On the other hand if the FTSE rises by 10% the investor will receive a 107.7% return on their initial investment, 100% from the zero coupon bond and 7.7% (77% of the 10%) from the warrant. 

An Insurance Policy

Covered Warrants give investors the ability to in effect take out an insurance policy over their investment portfolio. This is achieved by buying a Put warrant which effectively guarantees a minimum value for a portfolio or underlying security.

This is equal to the exercise price of the warrant. Should the market fall, the value of the portfolio will decrease. However, this loss can be either partially or fully offset by the rise in value of the put warrants since a put warrant rises in value as the underlying security or index falls in value.

This insurance quality of Covered Warrants is now being utilised by investors who manage their own investments through a Self Invested Personal Pension (SIPP).  Our pensions are our incomes of the future and provide the peace of mind that we will be able to enjoy our retirements in relative comfort.

The fall in value of the FTSE 100 from highs of 7000 in 2000 to the lows of 3000 in 2003 have left some SIPP users nursing their wounds. 

Now these investors are able to insure against significant falls in their pension value though ‘hedging’ their investments through Put warrants, and therefore take comfort in the knowledge that they are actively protecting their future lives.

When hedging consideration must be given to how closely a given index will replicate your portfolio. The poorer the correlation, the less exactly the warrant will offset losses in the portfolio at expiry. Portfolios with high concentrations of individual holdings may be better off hedging individual stocks.

In any case, issuers will work with the investors to find the most appropriate hedge, potentially even issuing a new put warrant where necessary.

Cash Extractors

Cash extraction is another way to use covered warrants and can be used either to release money from an existing portfolio for other investments, or as a replacement for an investment in an underlying equity, fund or index which has not yet been made.

This therefore allows investors the ability to maximise their cash flow by using their money more economically over a wider variety of areas at one time.

For example, an investor who has a portfolio valued at £100,000 in five blue chip stocks requires half this sum to cover a deposit for a flat for their child.  The investor is concerned that the stocks held are due an upward run and therefore does not want to miss the growth / profit potential.

By selling sufficient shares in the five blue chip companies the investor is able to meet the deposit requirements on the flat whilst also buying sufficient Call Warrants in the five blue chip companies to replicate the holdings original value and therefore will still enjoy any upside potential of the original portfolio.

Cash extractors might also use covered warrants to reduce their exposure to the market during uncertain economic periods, whilst ensuring that in the event the market does rise they are able to enjoy the financial benefits.

While the risk to the amount invested in the Call warrants will be higher than if the investor had remained fully invested, the released assets can be placed into a high rate savings account to enjoy the peace of mind of a risk-free environment, thereby giving a strictly limited downside.

This is a conservative strategy, and will appeal to those new to warrants, but cash extraction can also be a valuable tool for more sophisticated investors who want to maintain exposure to high risk investments while maintaining a strictly limited downside. 

A company thought to have the potential for a sharp rise in value, but also having the risk of a dramatic share price slump - e.g. a pharmaceutical company expected to announce trial results - would be an ideal target for investment using warrants rather than buying the equity directly.

New Frontiers

Warrants linked to individual shares and indices are still the most common, and the most widely traded, but innovative new warrants and tracker certificates are now being offered by UK issuers.

Investors can now gain exposure to currencies and commodities and these warrants can offer a more exciting and fast moving alternative for investors who are looking for something different.

The new range of commodity warrants gives access to a range of assets which would not otherwise be accessible to the retail investor, such as gold, silver, platinum and oil. 

These markets were previously the preserve of professional traders with prohibitively large market sizes - in excess of £250,000 for one contract of Platinum for example - but investors can now gain exposure for just a few pounds.

As with all other warrants, commodity warrants offer leveraged exposure to the underlying asset - e.g. Brent Oil - and are available as both puts and calls.  Commodities can be very volatile - over the past decade for example Brent Oil has traded between $10 and $50 a barrel, and even over recent weeks the fluctuations in price have been enough to give returns of over 400% on some of the warrants in issue.

Although commodity warrants work in essentially the same way as those on equities and indices, there are additional factors to consider.  One of the most important is the impact of currency fluctuations -gold for example is always priced in dollars.

Although a gold warrant may be priced and settled in sterling, the warrant itself will have a currency exposure resulting from the fact that gold is always priced in dollars, and the price of the warrant will therefore not necessarily move in line with the price of the underlying.

This additional complexity can work to the investor’s advantage, but only if he understands the impact each of the underlying factors might have on the value of the warrant.

With over 1,000 covered warrants tradable on the London Stock Exchange - covering equities, indices, currencies and commodities - there are already products to suit almost every investor, and the good news is that the issuers are constantly developing new warrants with an ever-increasing range of underlying assets.

There has never been a better time to learn more about warrants and how they can form an integral part of your portfolio.

Entry Filed under: SUPPLIER AND TECHNOFIN®, Covered Warrants