Saturday, 8 September 2012

Structured Warrants

Structured warrants were introduced in Singapore many years ago. They are synthetic derivatives created by investment banks and allow investors to gain in the price movement of a stock without the full capital layout. For example, a stock could be trading at $2.00 per share, which means that investors need to fork out $2,000 for 1 lot of shares. However, a 2-month structured call warrant could be created with a strike price of $1.90. The price of the structured warrant would be $0.16, or $160 for 1 lot of warrants. When the mother shares rise by $0.10, the structured warrant would rise by $0.08. While the gain on the mother shares is only 5% ($0.10 / $2.00), the gain on the structured warrant is 50% ($0.08 / $0.16). Conversely, should the mother shares fall, the loss is also magnified. Because of this leverage effect, structured warrants had been very popular with retail investors.

Although structured warrants are sold by investment banks, they do not lose with investors gain. This is because each structured warrant sold is backed by actual shares in the mother company. When investors buy a call warrant, the issuer will buy an equivalent number of shares in the mother company, so that any loss on the call warrant is covered by the gain on the mother shares. The issuer, which also acts as the designated market maker, stands ready to buy or sell any structured warrants that investors wish to trade. Hence, any movement in the price of the mother shares is quickly reflected in the price of the structured warrants.

However, what is not so obvious to investors is that any movement in the price of the structured warrant also has an impact on the price of the mother shares. A striking example happened sometime in 2005 in one of the structured warrants of Total Access Communications (TAC). Then, a pricing error by the market maker caused the structured warrant to be worth less than its equivalent of the mother shares. This created an arbitrage opportunity to buy the structured warrant and sell the mother shares for a risk-free profit, creating upward pricing pressure on the structured warrant and downward pressure on the mother shares. However, as the market maker maintained the price of the structured warrant, the end result was a drop in the mother shares. This event eventually passed as a pricing error and very little attention was called to the power of structured warrants to influence the price of the mother shares. However, this example shows that the power of structured warrants cannot be underestimated, especially when large volumes of structured warrants are traded on a single stock.

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