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The risk versus return trade-off

LAST week this column provided a broad introduction to the warrants market. This week, we discuss a number of trading and investment opportunities using warrants.

Instalment warrants are suitable for a broad range of investors. They give investors the potential for higher yields with lower outlays compared with buying shares.

Instalment warrants involve purchasing securities by making several payments over the life of the warrant. Societe Generale likens instalment warrants to having a share on lay-by.

The attraction of instalment warrants is that investors are entitled to receive all dividends and franking credits, and benefit from capital appreciation as if they owned the share, despite only paying a portion of the cost.

Many investors purchased instalment warrants as part of the privatisation of Telstra and Commonwealth Bank. Holders of Telstra2 instalment receipts discovered the risk of these securities when they had to make a second payment that took their total outlay to more than the prevailing share price.

Conventional instalment warrants involve a 50 per cent payment up front with the balance due on maturity. This means the warrants are geared at 50 per cent, since investors are effectively borrowing the balance from the issuer.

High-yield instalment warrants involve a much larger residual payment – 65-95 per cent of the underlying share price. Citibank’s Michael Walker says high-yield instalment warrants involve higher gearing and the potential for higher returns, but also carry higher risk.

They tend to be more suitable for investors with a strong view on the underlying share.

The most popular form of warrants are equity call warrants, which give the holder the right to buy an underlying security at an agreed price on or before a specified date.

Equity put warrants are similar, except they give the holder the right to sell the underlying security.

Macquarie Bank’s Dale Raynes says trading activity in warrants generally corresponds to shares that are volatile or actively traded, such as News Corp, Telstra and BHP.

He says equity warrants offer traders a means of speculating on the underlying shares for a small initial outlay. The size of the initial outlay, and the degree of risk, is up to the individual trader.

For instance, investors could buy out-of-the-money warrants (ie the exercise price is below the current share price) for just a few cents. These warrants are risky but offer the possibility of very high returns.

An example of the large potential gains from warrants trading occurred last week, when Qantas announced the purchase of Impulse Airlines. While Qantas’ share price jumped 71 cents to $3.40, one series of call warrants (QANIMB) zoomed from 2.7 cents to 37.0 cents.

The next day, many traders decided Qantas had been overbought and therefore purchased put warrants, pushing up the price of the QANWPP series from 7.4 cents to 9.8 cents.

The holders of the warrants would have achieved much higher returns than holders of the underlying shares.

The price of warrants is driven primarily by three factors – the price of the underlying security, the expected price fluctuations or volatility, and the time to maturity.

Citibank’s Michael Walker says these factors do not always work in the same direction.

For instance, a rise in the price of the underlying asset and higher volatility will increase the price of a call warrant but this may be offset by “time decay” as the warrant moves closer to maturity.

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