Originally published by OpenMarkets
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 (NYSE:C)) |
| CBA |
| Macquarie Bank |
| RBS Alternative Investments (Aust) |
| Royal Bank of Scotland (LON:RBS) |
| 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:
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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.