Covered Warrants I

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10. Types of covered warrant I (warrant terms)

There are many different types of covered warrant possible. However, in the early days of the new market, it’s likely that issuers will stick to what are usually called ‘plain vanilla’ warrants. These are warrants with straightforward terms, a simple right to buy or sell an individual stock or index. Once the market develops though and issuers become more bold with their offerings, all kinds of varieties are possible.

This section covers a number of varieties of warrants which have been issued in other markets, some of which might eventually make an appearance in the UK.

Calls and Puts

Using covered warrants you can make money if the market goes up, and you can make money if the market goes down. Investors familiar with spread betting or with traded options will understand this approach which allows a judgement to be backed either way, but ordinary share investors may not. As a consequence, however, of the protracted decline in share prices at the start of the new millennium, investors have generally become more aware of the benefits of downside protection or speculation.

Example

European and American

You may come across the terms European style or American style to describe the exercise terms of covered warrants. The distinction is straightforward -

• European style exercise means that the warrants may only be exercised on a specific date, or range of dates.
• American style means that the warrants can be exercised at any time up to their expiry date.

In some markets there is an historic precedent which means that investors are more used to one style; or in some cases an issuer will always stick to one style, but neither seems to have any great advantage over the other.

1. For issuers the European style is in some ways simpler because exercise occurs infrequently, or perhaps just once at the end of the warrants life.
2. For investors the American style might be slightly preferable because it is more flexible for those who do wish to take up exercise rights, and because there is no distortion of the pricing curve. In practice, it probably doesn’t matter too much. Few investors ever exercise covered warrants in any case, and the existence of a premium before final expiry usually makes it uneconomic to exercise American-style warrants early.

Warrants per Share

Nearly all of the traditional warrants listed on the London Stock Exchange are exercisable into their shares on a one-for-one basis. One warrant entitles the holder to subscribe for one share. But this does not necessarily hold for covered warrants.

The number of warrants required to exercise into one share, or its cash equivalent, could as easily be 0.5, 5, 10, or 100 as it could be one. This is frequently called the cover ratio, although it is also called the subscription ratio, the exercise ratio, the conversion ratio, the entitlement ratio, the parity ratio, the multiplier, the set, or just the plain ratio. If 50 warrants are required to exercise into one share, the cover ratio is 50, or 50:1.

Cover ratios are rarely 1:1 for index warrants, nor for other securities which have a high absolute price. The purpose of 5:1 or 10:1 cover ratios is to reduce the covered warrant price down to an easily marketable and tradeable level.

Note: When analysing any warrant, and when comparing different warrants, it is essential to check the cover ratio. If a valuation seems far too low or too high to be true, it probably is, and the answer may well lie with an incorrectly assumed cover ratio. A sensible approach when comparing warrants with different cover ratios is to ensure consistency by, for example, restating all prices on a ‘per warrant’ basis.

Stock Warrants

More warrants will be issued over single stocks than anything else. The majority of covered warrants are typically issued over the largest local companies, with a sprinkling of well-known global stocks to add an international dimension. In the UK the prime focus will be on constituents of the FTSE 100 Index, which are generally household names.

Multiple issues
There will not be just one warrant per company. Competing issuers may each issue warrants over the most popular stocks, such as Vodafone, with perhaps more than one series apiece. If Vodafone shares are trading at 100p then an issuer might issue a series of call and put warrants with exercise prices of 60p, 80p, 100p, 120p, and 140p to cater for investors with different gearing and premium requirements.

It is easy to see how the number of warrants in issue can quickly multiply, assuming there is a reasonable level of demand. This is especially true when markets have made a significant move in either direction, because certain series of warrants effectively become defunct as the price moves away from the issue level.

1. Introduction 2. What are covered warrants? 3. Comparison between corporate warrants and covered warrants 4. Advantages of warrants 5. Advantages of warrants – the magic of gearing 6. Disadvantages of warrants 7. Advantages & disadvantages - a summary 8. International warrants markets 9. UK warrant market 10. Types of covered warrant I (warrant terms) 11. Types of covered warrant II (underlying assets) 12. Types of covered warrant III (exotics) 13. Information on warrant terms 14. Warrant trading 15. Warrant pricing 16. Basic analysis I (underlying asset) 17. Basic analysis II (prices and terms) 18. Basic analysis III (gearing) 19. Basic analysis IV (intrinsic value) 20. Basic analysis V (premium) 21. Advanced analysis I (Black-Scholes Model) 22. Advanced analysis II (volatility) 23. Advanced analysis III (the greeks) 24. Risk 25. Trading strategies 26. Tax 27. Conclusion

• Andrew McHattie on Covered Warrants