Derivative Warrants

Equity warrants are issued by a listed company.  They give holders the right to subscribe for equity securities of the issuer.  Equity warrants are often issued together with new shares in IPOs, or distributed together with the shares acquired for any dividend payment, bonus issue or rights issue.  Equity warrants have a life of one to five years.  When these warrants are exercised, the listed company will issue new shares to their holders and collect extra capital.  The issuer of a warrant must specify whether it is settled by cash or by physical delivery of the underlying assets. 

"Derivative warrants" fall under the category of derivative investment instruments or structured products.  They have a life of six months to five years.  The underlying assets of derivative warrants include ordinary shares, market indices, currencies and baskets of shares.  Derivative warrants are issued by a third party, generally an investment bank, independent of the issuer of the underlying assets.  The issuer of derivative warrants may not be the issuer of the underlying assets but should hold or have a right to hold the underlying assets.

Derivative warrants can be linked to a single security or a basket of securities, stock indices, currencies, commodities or futures contracts (like crude oil futures).  Almost all derivative warrants currently traded in Hong Kong are cash-settled.  Warrants linked to a basket of securities, stock indices or securities listed in other jurisdictions will always be settled by cash.   

When a physically settled call derivative warrant on a single stock is exercised, the warrant holder will receive the underlying stock from the issuer.  Unlike equity warrants, no new shares will be issued. 

The issue and exercise of derivative warrants has no effect on the quantity of the underlying assets (such as ordinary shares).  Derivative warrants provide the market with a wider range for instruments for hedging or investment purposes.

Those who buy call warrants usually hold a bullish view of the price of the underlying asset.  The holder of a call warrant may sell the warrant or wait until the expiry date.  At the expiry of a call warrant, if the price of the underlying assets is higher than the derivative warrant's exercise price, the derivative warrant is "in-the-money" and will be exercised automatically.  The holder of a cash-settled derivative warrant (almost all derivative warrants currently listed in Hong Kong are cash-settled) will receive a cash payment of an amount equal to the positive difference between the settlement price and the exercise price of the call warrant adjusted by the entitlement ratio.  The settlement price of a call warrant is the 5-day average closing price of the underlying assets prior to the expiry date.  On the expiry date, if the settlement price of the call warrant is lower than its exercise price, the derivative warrant is “out-of-the-money and will become worthless.

Buyers of put warrants usually hold a bearish view of the price of the underlying assets.  The holder of a put warrant can sell it or wait until expiry.  At the expiry of a put warrant, if the price of the underlying assets is lower than the derivative warrant’s exercise price, the derivative warrant is “in-the-money” and will be exercised automatically.  The holder of a cash-settled warrant (almost all derivative warrants currently listed in Hong Kong are cash-settled) will receive a cash payment of an amount equal to the positive difference between the exercise price of the put warrant and the settlement price of the underlying assets adjusted by the entitlement ratio.  The settlement price of a put warrant is the 5-day average closing price of the underlying asset prior to the expiry of the warrant.  On the expiry date, if the settlement price of the underlying assets is higher than the exercise price, the derivative warrant is “out-of-the-money” and will become worthless.

Investors should note that if trading in the underlying assets of a derivative warrant is suspended, trading in the warrant will also be suspended until trading in the underlying assets resumes.  In addition, to ensure that a trade executed on the last trading day has sufficient time for settlement and any registration, there shall be three settlement days between the last trading day and the expiry day.  In general, trading days are also settlement days, except that Christmas Eve, New Year’s Eve and Lunar New Year’s Eve will normally be prescribed by the Exchange as non-settlement days.

1. Issuer risk: Derivative warrant holders are unsecured creditors of the issuer and they have no preferential claim to any assets an issuer may hold.
2. Gearing risk: Although derivative warrants often cost less than the price of the underlying assets, a derivative warrant may change in value to a much greater extent than the underlying assets.  Although potential return on derivative warrants may be higher than that on the underlying assets, it should be noted that in the worst case the value of derivative warrants may fall to zero and holders may lose their entire investment amount.
3. Limited life: Unlike stocks, derivative warrants have an expiry date and therefore a limited life.  Unless the derivative warrants are in-the-money, they become worthless at expiration.
4. Time decay: So long as other factors remain unchanged, the value of derivative warrants will decrease over time. Therefore, derivative warrants should never be viewed as products that are bought and held as long term investments.
5. Market forces: In addition to the basic factors that determine the theoretical price of a derivative warrant, derivative warrant prices are also affected by the demand for and supply of the derivative warrants.  This is particularly the case when a derivative warrant issue is almost sold out and when there are further issues of an existing derivative warrant.
6. Turnover: High turnover should not be regarded as an indication that a derivative warrant’s price will go up.  The price of a derivative warrant is affected by a number of factors in addition to market forces, such as the price of the underlying assets and its volatility, the time remaining to expiry, interest rates and the expected dividend on the underlying assets.

For index warrants, the settlement price is usually based on the final settlement price of the corresponding index futures contract of the same expiry month traded on the Futures Exchange.

Price volatility

The trading price of a zero/low strike MAP tends to mirror the movement of the value of the underlying assets and any corresponding foreign currency, both of which can be very volatile.  In addition, MAP may be subject to possible adjustments for dividend payments (if any) and management fees charged by the issuer if applicable.

Degree of tracking error

Although the trading price of a zero/low strike MAP tends to track the movement of the value of the underlying assets and any corresponding foreign currency, there may be a certain degree of tracking error depending on how the prices of individual MAP are adjusted for the payment of management fees, treatment of dividends by the underlying equity indices (if any) and the bid-ask spreads when MAP are traded on the Exchange.  Investors should refer to the listing documents of MAP or consult the issuers or their investment advisers for details.

Exchange rate risk

Unlike MAP which are traded and settled in Hong Kong dollars, the trading prices of the underlying assets of MAP, which are not hedged against foreign exchange risk, will normally be quoted in a foreign currency and thus there is exchange rate risk involved.

Exposure to issuers

Similar to other structured products, MAP are not collateralised and are subject to the creditworthiness of the issuers.

Derivative warrant issuers are required to appoint a liquidity provider for each of their listed derivative warrants.  In Hong Kong liquidity providers for derivative warrants are commonly known as “market makers”. Each liquidity provider is identified by a 95XX, 96XX or 97XX code.  The listing document of an issuer sets out the exact obligations of the liquidity provider.

In normal circumstances, liquidity providers should provide liquidity for derivative warrant issues through continuous quotes or in response to quote requests from five minutes after the market opens until the market closes.  The liquidity provider should provide liquidity for at least a certain number of board lots of the derivative warrant.  An issuer must specify the maximum spread between the bid and offer prices for its derivative warrants in the listing document.  Under the quote request system, investors may request a quote from the liquidity provider.