Friday, March 7, 2008

Structured warrants - Love or hate them?

A few days ago, the local newspaper reported that despite the current bearish sentiments in the Singapore stock market, financial institutions are still continuing to issue structured warrants on the exchange. The reasons these institutions give to encourage investors to buy them include leverage, hedging of risk...... blah, blah.

Make no mistake, the issuing of these structured warrants are cash minting machines for these financial institutions. For those that are unconvinced, pls talk to friends or relatives working in the structured warrants department of these institutions. I believe it will be interesting to find out if the top management of these companies make use of such warrants in their own investment plans. But that is another story for another day.

There are a few reasons why these structured warrants generate income. Firstly, they are being issued at a premium. Generally, one could use the black-scholes formula to calculate the warrant's fair price. So strictly speaking, if one buy the warrants on its listing day, one is overpaying for it. Would you pay $1.3 for a dollar note?

Secondly, the financial institution's risk are fully hedged using the dynamic delta hedging process. Of course there are variations of how this can be carried out. In short, the institution will go out on the open market to buy and sell the underlying share in order to maintain a delta neutral position. It doesn't matter whether the price of the underlying share goes up or down. Under ideal conditions, the income earned will be equal to the premiums charged. However, in reality, this amount can fluctuate too. But not to worry, at the end of the day, the institutions will still collect their cheque.

To sum up, issuing of structured warrants, which picked up over the past few years, are new methods of generating income for these institutions. Please open your big eyes to understand the big picture before putting in your hard-earned money.


musicwhiz said...

Hi level13,

Yes I agree structured warrants are simply another way for these institutions to suck your money. The pricing is not very transparent as they have to act as the "market-makers" which means they have to mop up the warrants should there be no liquidity.

Warrants are also short term instruments and thus prone to much volatility, hence I would not term people who buy warrants as "investors" but more of speculators or gamblers. This may sound extreme but in the short-term, there is no reliable way to tell whether the market will go up or down and by what magnitude. The stock market is a complex adaptive system with too many variables.

Of course, warrants will continue to thrive as people always want to believe they can make a quick buck (look at the queues for the Toto and 4D booths). But in the end, people usually end up barely breaking even or losing their pants over warrants (I know a few such cases).


TheKen said...

hi whiz lol

i totally agree about structured warrants, its really xxxxxx-xx, sad that we can't do much about it.

anyway level13, would you like to exchange links with both my personal blog and another website ? whiz i sent u a pm too by cna forum

pls get back to me, email kendrickyeo at hotmail dot com

level13 said...

It is the intention of our government to turn Singapore into a financial hub so as to compete against the likes of Tokyo and Hong Kong. As such, licenses are issue to financial institution for them to list more sophisticated financial instruments (structured warrants). However, what is good for them may not necessary be good for retail investors. Understanding, knowledge and caution are still the key words.