Covered Warrants I
No course on warrants is complete without a section on the four-letter word: R I S K. Ignore it at your peril. The lengthy risk warning you will encounter before you can deal through a stockbroker, and on any advisory material, is there for your benefit.
One of the simplest yet most powerful graphs to be found in investment literature is a simple 45% line sloping upwards from the left, with risk and reward on either axis. The greater the potential rewards sought, the greater the risk that must be taken. There is no investment reward without risk. Warrants are of course well along the risk-reward spectrum.
There are three reasons why covered warrants stand higher on the risk spectrum than traditional company and investment trust warrants:
- covered warrants tend to be more highly geared;
- they tend to be shorter-dated; and
- there is an additional layer of credit risk from the issuers as the counterparty to transactions.
Asset price risk, amplified by leverage, is generally the main risk associated with warrants, but there are three more classes of risk to be aware of, namely takeover risk, credit risk, and currency risk.
- Takeover Risk. For warrant holders, takeovers can be a disaster because of the immediate and complete loss of time value which can wipe out the value of warrants entirely. Overall it is doubtful whether this is likely to become a great problem for warrants on UK blue-chip companies, where their sheer size means that cash offers are rare. It is an issue to bear in mind though, and you should be careful about buying out-of-the-money warrants if part of your reasoning is based on some expectation of a takeover.
- Credit Risk. In view of the stringent London Stock Exchange requirements for the financial standing of issuers, and the high levels of disclosure required, it seems unlikely that an issuer of a covered warrant would default, but this is a potential credit risk. If you have any doubts about the financial strength of a warrant issuer, you should not buy their warrants.
- Currency Risk. It may be that the covered warrants market in the UK will bring a number of overseas shares and indices into the investable realm for private investors. But it does bring currency risk along with it. It is possible that currency movements could wipe out potential gains on a warrant, so again this is a question you should try to address – or at least be aware of – before investing.
It is important to remember that there is a risk of total loss when investing in a warrant. You should not invest with money you cannot afford to lose, no matter how supremely confident you might be at the outset.
There are a number of sensible steps which can be taken to reduce risk:
- Always check the price and terms before dealing
- Invest a sensible amount
- Monitor prices regularly
- Consider using stop-losses