Covered Warrants – an Introduction

FLEXIBILITY THAT CAN DELIVER MAGNIFIED RETURNS Covered warrants – an introduction COL4319_LSE covered warrants introduction.indd 1 10/6/09 6:53:11 PM Contents What is a covered warrant? 2 Types of covered warrants 3 Features of covered warrants 5 Pricing of covered warrants 8 Comparison of covered warrants 9 Strategies and risks involved 10 How to start using covered warrants 12 Q&A 14 Glossary 15 2 1 COL4319_LSE covered warrants introduction.indd 2 10/6/09 6:53:39 PM Covered warrants – an introductory guide Covered warrants were made available to UK private investors for the first time when they were introduced on the London Stock Exchange in October 2002. These versatile instruments, which have already proved popular in other countries, offer a variety of investment solutions for a range of investors. This guide is designed to introduce covered warrants and to help you decide whether they meet your investment needs. The brochure outlines the different types of covered warrants available, considers their benefits and features, and also the risks associated with them. 2 1 COL4319_LSE covered warrants introduction.indd 1 10/6/09 6:53:40 PM What is a covered warrant? Covered warrants are listed securities issued by financial institutions and then made available for Fact box trading on the London Stock Exchange. A covered One of the questions many investors ask is warrant gives the holder the right, but not the where the name comes from – why are they obligation to buy or sell an underlying asset, at a called covered warrants? The term ‘covered’ specified price, on or before a predetermined date. denotes the fact that when the issuer sells a warrant to an investor, they will often For many investors, covered warrants will seem ‘cover’ (hedge) their exposure by buying the similar to options. Covered warrants typically have underlying stock in the market, or by using longer maturities than options, and are issued other instruments. Covered warrants have on over a wider range of assets. The terms are also average a life of six to twelve months, although more varied – covered warrants are highly flexible some have a longer (or occasionally open- and can be issued with terms structured to meet ended) lifespan. They can be bought and sold market demand. at any point during their lifetime. With covered warrants you cannot lose more than your initial investment. Your maximum loss is known in advance, and there are no margin calls, ie further payments to maintain your position. This differentiates covered warrants from some other forms of derivatives. 2 3 COL4319_LSE covered warrants introduction.indd 2 10/6/09 6:53:40 PM Types of covered warrants Stock warrants Commodity Covered warrants on single stocks represent It can be difficult for private investors to gain a significant number of those available. The main exposure in sterling to major commodities. Using focus is on popular UK ‘blue-chip’ shares. There covered warrants it is possible for investors to are also some covered warrants on popular shares take positions on commodities in small size and in other markets. in sterling. Baskets Currency For exposure to a particular theme or sector, The same applies to currencies. Covered warrants a number of stocks are sometimes grouped are available on a range of exchange rates. together in a ‘basket’. Investors can then obtain exposure to this basket simply and efficiently by buying one single security in the form of a covered warrant. Index In most covered warrant markets around the world, the most actively traded instruments are those on the main domestic market index. In the UK, the FTSE 100 Index has been a consistently popular underlying. Covered warrants have also been issued over other UK market indices such as the FTSE 250 Index, and a range of overseas indices including the Dow Jones Industrial Average, Nasdaq 100 Index, Nikkei 225 Index, Hang Seng Index, DAX Index, CAC 40 Index amongst others. 2 3 COL4319_LSE covered warrants introduction.indd 3 10/6/09 6:54:03 PM Covered warrants offer a wide variety of underlying products including equities, indices, commodities and currencies. 4 5 COL4319_LSE covered warrants introduction.indd 4 10/6/09 6:54:41 PM Features of covered warrants Calls and puts Conversion ratio Covered warrants exist in two basic forms – The conversion ratio is the number of covered a call or a put. They allow the holder to benefit warrants required to gain exposure to one unit of from either a rising or a falling market. the underlying asset. It is sometimes called parity, The holder of a covered warrant has the right but the cover ratio, or simply the ratio. not the obligation to either buy (call) or sell (put) an underlying asset at a predetermined price (known Exercise style as the exercise or strike price) on or before a Covered warrants can either be European or certain date in the future. A call warrant usually American style. A European-style warrant allows rises in value when the underlying asset rises in you to exercise your right only on the expiry date, value, whilst a put warrant usually rises in value whereas with an American-style warrant you can when the underlying asset falls in value. do this at any time between the date of issuance and the expiry date. In practice, this distinction Expiry date has little influence over covered warrant pricing or Covered warrants usually have a predetermined trading given that during the lifetime of the covered maturity which is set when the warrant is first warrant selling the instrument will almost always issued. The expiry date is the last date that the be more profitable than early exercise. covered warrant can be exercised. Intrinsic value and premium/time value Strike price (or exercise price) Covered warrant prices are typically composed The strike price represents the price at which the of two elements. The first element is the value investor has the right to buy (call) or sell (put) an which a covered warrant would have if it were underlying asset. Covered warrant issuers often to be exercised immediately, which is called issue a range of strike prices over each underlying the intrinsic value. In the case of a call covered security, providing investors with a choice of warrant, for example, carrying the right to buy one covered warrants to reflect their particular view share at 100p, if the underlying share is trading of the market. at 150p, then the covered warrant (assuming a conversion ratio of 1:1) has an intrinsic value of 50p. In practice, however, the covered warrant will trade at a market price higher than 50p. There is a second element in the price, namely time value, which reflects the time to expiry. Time value diminishes as covered warrants near their final maturity. 4 5 COL4319_LSE covered warrants introduction.indd 5 10/6/09 6:54:42 PM Loss of time value Gearing As a general rule of thumb, covered warrants lose Gearing is calculated by dividing the asset price one-third of their time value during the first half of by the covered warrant price (adjusted for the their lives, and two-thirds during the second half. conversion ratio if necessary). If an underlying The accelerating loss of time value on approach share price is 100p, for example, and a covered to expiry means that short-dated warrants with warrant with a ratio of 1:1 is trading at 20p, the significant levels of premium can carry a high risk. gearing is five times. This figure measures the amount of additional exposure gained by investing Gearing and leverage in covered warrants rather than directly in the For most investors a prime reason for buying underlying asset. An investor buying a warrant at covered warrants is the gearing or leverage which 20p is effectively gaining exposure to an asset they offer. Both terms relate to the capacity of worth 100p – five times as much. covered warrants to magnify returns. This gearing benefit can be interpreted aggressively or defensively. The former means that investors can invest their normal investment sum in covered warrants, thereby ‘gearing up’ and gaining exposure to a much larger asset value. The alternative is to ‘gear down’ and to gain the same exposure by investing a lesser amount in covered warrants. This latter strategy can be used to reduce the potential maximum loss from a holding. 6 7 COL4319_LSE covered warrants introduction.indd 6 10/6/09 6:54:42 PM Leverage Key benefits of covered warrants Often, investors are most interested in the extra • offer access to a range of markets, including degree of price movement which covered warrants international markets can provide exposure to. This is not measured • offer a wide variety of underlying products by simple gearing, which usually overstates the including equities, indices, commodities and multiple of movement, but by leverage, sometimes currencies called elasticity or ‘effective gearing’. • give you the opportunity to expand your Leverage is calculated by multiplying simple portfolio in new directions without actually gearing by another indicator called the delta, and buying the underlying products measures the additional degree of price movement which might be expected from the covered • provide gearing, but limit the risk to the warrants. Covered warrants with leverage of four amount invested times, for example, might be expected to move • all covered warrants are ‘cash-settled’ – the four times as much in percentage terms as their gain achieved on the covered warrant is underlying asset. transferred to the holder without the holder Leverage should only be used as an approximation, having to carry out a buy or sell trade – this however, as the figure changes constantly with means holders do not have to pay stamp changes in the price of the underlying asset, the duty that is usually incurred on UK share covered warrants, and with the time remaining purchases to expiry.

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