Thursday 28 Mar 2024
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THE recent sharp plunge in the regional equity markets has scared off many investors as their gains evaporated fast. But the wild swings in the indices have whetted risk-taking investors’ appetite for index-linked structured warrants issued by investment banks — an investment tool that the old-school conservative would, however, label  as a risky alternative.

In recent weeks, such warrants (for example FBM KLCI-HG, FBM KLCI-HM, CHINA50-H1 and HSI-HA) are the regulars on the Top 30 most actively traded securities on Bursa Malaysia.

As a rule of thumb, structured call warrants are meant for bull markets while put warrants are the handy trading tool in bear markets. Their prices would move in tandem with the futures contracts of the particular underlying indices.

how-to-put-warrant-works_cap40_1075_theedgemarketsFor instance, put warrants such as CHINA50-H1 and HSI-HA, which are pegged to the China A50 Index and Hang Seng Index respectively in Hong Kong, make money when the market falls. They are actively traded on Bursa every day amid the meltdown in both the China and Hong Kong stock markets that had experienced euphoric rallies since the beginning of this year.

In fact, CHINA50-H1 gained 137% in a single trading day on July 8. Similarly, several put warrants based on the Hang Seng Index hit limit-up prices on the same day, making them a highly profitable investment for those who read the market’s direction correctly.

Closer to home, warrants linked to the movement of the FBM KLCI are also available. At present, there are about 40 call and put warrants issued at different prices that allow investors to trade on the direction of the benchmark index.

Nonetheless, the fundamental investors are probably raising their eyebrows at such derivatives. As investment guru Warren Buffett puts it: Derivatives are time bombs, both for the parties that deal in them and the economic system.

This raises the question as to whether Malaysian retail investors understand the risks associated with trading the index-linked structured warrants.

That said, warrant specialists would beg to differ. For instance, you could have “straddle” or “strangle” strategies that are meant for highly volatile market.

By doing that, you would probably make less money, but your risk level is lower.

A straddle entails buying in-the-money call warrants and the same in-the-money put. The idea is that should the underlying significantly increase or significantly decrease, such that the new value of the call or the put can be sold for more than the cost to purchase the two positions, you profit.

A strangle takes the same approach but uses an out-of-the-money call and an out-of-the-money put to reduce the cost. This is a lower cost trade but requires an even greater move to be profitable.

In an interview with The Edge, Macquarie Securities Group head of Southeast Asia equity derivatives Barnaby Matthews disagrees that investors are not aware of the risks. “We believe they are well informed that these are trading instruments. On our part, we have created a website (www.malaysiawarrants.com.my) that provides educational tools as well as a live matrix system that shows the market maker’s bid and offer prices for the warrants. That said, there is no doubt that the recent market movement is well outside historical norms.”

Previously, to gain exposure in the China and Hong Kong markets, an investor would have to trade the futures contracts that are traded on overseas exchanges. This is highly costly due to the substantial margin requirements as well as inter-exchange transaction fees as the contracts would have to be purchased through a Malaysian brokerage house.

In comparison, some of the index-linked warrants currently available are trading at prices comparable to penny stocks and offer a greater degree of leverage. However, the risks are magnified.

Macquarie, which is the issuer for all the foreign index-linked warrants traded on Bursa currently, has to act as a market maker to ensure liquidity as well as orderly trading. However, because of Bursa regulations on the dynamic price limits on all securities, there are times when the investment bank is unable to provide the necessary liquidity, says Matthews.

“Investors can be left trapped in the warrants at limit-up and limit-down prices. We do not believe that the dynamic price limits that apply to stocks should apply to the derivatives, and we have conveyed investors’ concerns about this to the regulator,” he adds.

The introduction of the foreign index warrants by Macquarie in October last year coincided with the strong rally on the Hang Seng and China’s various stock markets. Awash with liquidity and the ability to buy at generous margin multiples, individual investors in China had pushed up the market to stunning heights, as evidenced by the China A50 Index, which consists of 50 largest China-based companies in terms of market capitalisation in Hong Kong, doubling in value within six months.

As market liquidity is the key component of a vibrant stock market, Matthews believes that the growth in the issuance of index-linked warrants is a positive development for the local bourse.

“Stock-based derivatives and options make up about 50% of all daily turnover in the stock markets of developed countries. We do foresee more demand in Malaysia for these instruments, if the recent high trading volume of the puts and calls is any indication,” he says.

Nevertheless, there are instances when the trading in the warrants do not reflect the underlying movements of the markets that they represent. For example, the CHINA50-H1 put warrant gained as much as 30% on July 9,  despite the China A50 Index staging a strong rally after gaining as much as 6% on the same day. This could be due to pure speculative activity, which causes warrant prices to diverge from the underlying index value.

There is also the perception that investment banks, facing a decline in earnings due to the slowdown in deals this year, are incentivised to keep churning out these warrants at the expense of retail investors.

To counter this, Matthews explains how investment banks generate revenue as well as incur costs from issuing the warrants. “What we do is that we structure the warrant based on its implied volatility expectations. We only profit when hedging costs are less than what we sold the warrant for throughout its tenure.”

Hedging costs go up when markets are especially volatile, which he says is not an ideal scenario for the market makers. As the global markets are expected to continue to exhibit strong volatility in the coming weeks, Matthews advises investors to be properly informed on the risks and benefits of trading the warrants.

 

This article first appeared in Capital, The Edge Malaysia Weekly, on July 13 - 19, 2015.

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