For Peace of Mind: Volume 8 - Possibilities…

Portfolio Protection

Most investors do not have a disciplined investment process in place for buying, holding and selling investments. Hence most decisions tend to be made emotionally due to fear or greed (or a combination of both).

What is a Warrant

A warrant is a structured financial product issued by a financial institution or any other Australian Stock Exchange (ASX) approved institution. They are a form of derivative, in that their value is derived from another underlying asset. This underlying asset must also be approved by the ASX. They provide investors with an alternative way of gaining investment exposure to a variety of underlying assets, such as shares, to achieve a desired result. While there is a wide range of warrant types quoted on the ASX, all warrants give the warrant holder (purchaser) the right to buy or sell the underlying instrument. Share warrants (also referred to as equity warrants) are issued over securities and are the most commonly traded warrants. These share warrants represent an agreement whereby the holder obtains the right to buy or sell shares in a listed company. Investors pay a "premium" for the share warrant (which is the maximum amount of money that can be lost) and the value of the warrant increases or decreases depending on a number of factors, including the underlying share price to maturity.

Warrant Codes

All warrants traded on the ASX have a six letter code. The first three letters of the code identify the underlying security. For most equity warrants this is the same as the underlying company's three letter ASX code. Other times the letter may represent a basket of securities. The fourth letter identifies the particular type of warrant. For example; ‘I’ signifies an Instalment Warrant and ‘S’ signifies a Self Funding Instalment Warrant. The fifth letter identifies the Warrant issuer.

The sixth and last letter identifies the particular warrant series issued by the warrant issuer.

Legislative Requirements

Warrants are principally governed by the Corporations Act and the ASX Market Rules in section 7, 8 and 10, also referred to as the "Warrant Rules". The ASX Market Rules define a warrant as a financial instrument which give the holders the right:

• To acquire the underlying instrument (deliverable call warrant);
• To require the issuer to acquire the underlying instrument (deliverable put warrant);
• To be paid by the warrant issuer an amount of money to be determined by reference to either the amount by which a specified number is greater or less than the number of the index, or the amount by which the price or value of the underlying
instrument is greater or less than the specified price or value (cash settled put or call warrant);
• A Call Warrant - gives the holder the right to buy the underlying asset from the Warrant Issuer at a specified price on or before a particular date.

A Put Warrant - gives the holder the right to sell the underlying asset to the Warrant Issuer at a specified price (exercise price), on or before a particular date (expiry date).

What is the Purpose/Rationale of investing in Warrants in general?

There are many advantages to be gained from investing in warrants as opposed to investing in shares or other underlying assets, which include:

LEVERAGE: By buying a warrant an investor gains leveraged exposure to movements in the price or level of the underlying instrument. For example, equity warrants are typically worth only a fraction of the price of the underlying shares, and so offer much higher percentage returns (both positive and negative) than an investment in the shares themselves.

Two examples of this are shown below. Firstly we address the scenario where the investor is expecting shares in XYZ Pty Ltd to rise. In our hypothetical example XYZ shares are currently trading at $9.80, and a $10.00 call warrant over XYZ shares is trading at 60c. In this hypothetical example if the share price rises and is selling at $10.80 several months later, the shareholder has gained $1.00 before charges, or an increase of 10.2% over the purchase price. The warrant holder, on the other hand, has gained from the same rise in the price of the shares, but the percentage increase in the value of the warrant, or the return on investment, is greater than that of the share (66.67% in this example). This is the result of outlaying a smaller amount initially.

In the second example we have an investor who wishes to protect his shares in XYZ against a price fall. In this hypothetical example XYZ shares are currently trading at $10.80, and a $10.00 put warrant over XYZ shares is trading at 60c. In this hypothetical example if the share price falls and is selling at $9.80 several months later, the shareholder has profited $1.00 before charges, or an increase of 9.26% over the purchase price. The warrant holder, on the other hand, has once again gained from the same fall in the price of the shares, but the percentage increase in the value of the warrant, or the return on investment, is greater than that of the share (40.00%). This is the result of outlaying a smaller amount initially once again.

Be aware that leverage is a doubled-edged sword and any substantial adverse movement in the price of the underlying could see the value of the warrant quickly decrease.

DIVERSIFICATION: Warrants can give investors the ability to diversify their exposure to the sharemarket. By using instalment warrants for instance, investors are able to gain an equivalent exposure to an underlying asset on a per share basis, while retaining funds to invest into other assets if they choose to do so.

ENHANCED DIVIDEND YIELD: An attractive feature of instalment warrants is that investors are entitled to the full dividend and franking credits paid on the underlying asset, even though the investor has only partially paid for the share. As the instalment price may be 50% of the underlying share price or less, the dividend stream represents an enhanced yield compared to the income received by the holder of the fully paid share.

MARKET TIMING: Warrants give investors time to assess the performance of the underlying asset without having to outlay the full market value of their investment. The risk is limited and the investor buys time in which to consider the investment.

FLEXIBILITY: The variety of warrants traded on ASX provides flexible market exposure for investors without the requirement of owning the underlying security to which the exposure is sought. The various products types offer a variety of different risk/reward profiles, meaning that investors can chose from a product range that suits the most conservative to the most speculative investor.

Specific Issues and Potential Risks

All market-linked investments will rise and fall in value (to some degree) and are certainly not capital guaranteed investments. In addition to this, Warrants are leveraged instruments. Specific risks include:

UNDERLYING FAILS TO PERFORM: The success of an investment in a warrant depends primarily on how the underlying asset performs during the warrants life. If the underlying asset does not perform as expected the value of the warrant may decline significantly. This could even result in a 100% loss on the investment. If however a client has used a warrant as part of a hedging strategy the market underperformance of the warrant may be offset by corresponding movement in the underlying instrument.

TIMING CONSIDERATIONS: A warrant has a limited life and the desired change in the value of the asset must also take place before expiry of the warrant. Therefore an investor may be fundamentally correct with his or her view on the underlying instrument but if the market price of the warrant does not move in the required time frame once again the investor may potentially lose 100% of there initial investment. However no matter how the price of the underlying asset behaves, investors can lose no more than what they initially paid for the warrant. The measure of this "time decay" for this warrant is call the "Theta" of the instrument.

ISSUER CREDIT RISK: Neither the ASX nor its subsidiaries guarantee the performance of any warrant issuer. Since a warrant is a contract between the warrant issuer and the holder, investors are exposed to the risk that the warrant issuer will not perform its obligations under the warrant. There are stringent criteria on an institution must meet to be accepted as a warrant issuer. These are in place to minimise the credit risk of dealing with the warrant issuer. In the history of the ASX warrants market no warrant issuer has defaulted on its obligations to settle upon exercise of a warrant.

EARLY TERMINATION OF A WARRANT: In certain circumstances a warrant may terminate before the expiry date. Issuers often reserve the right to nominate certain extraordinary events, which may result in the early expiry of a warrant series. The types of events that may be nominated as an extraordinary event are set out in terms of issue of a warrant series. These events may vary depending on the type of warrant. Examples of this could include:
• The suspension of trading in the underlying security
• The de-listing of the underlying company
• The take over of the underlying company

LIQUIDITY RISK: Liquidity risk is the risk that investors may not be able to buy or sell warrants for a reasonable price in the market. There may be insufficient orders to buy warrants, or the price at which others are prepared to buy them is to low. While warrant issuers undertake to the ASX to make markets in their warrants, there are no bid offer spread or quantity obligations attached to this. In times of extreme volatility the ability of market makers to maintain a market may be put under stress. Investors should be aware that in these situations, the presence of suitable of suitable quotes in the market cannot always be assured.

MARKET RISK: The market price of a warrant is affected by the same factors that affect all stock market investments. These typically include movements in domestic and international markets, the present and expected economic environment, investor sentiment, interest rates, exchange rates and volatility.

BASIS RISK/TRACKING ERROR: The instrument used to hedge the portfolio may not move exactly in tandem with the underlying asset being hedged. This is particularly relevant in the situation where an investor uses a Put Index Warrant to hedge their portfolio and the subsequent aggregate price movements of their portfolio does not match that of the index exactly. This is due to the fact that typically investors have 10 to 25 stocks within their investment portfolio but the underlying index is based on the aggregate movements of the top 200 stock on the ASX. So for example if an investor does not hold BHP shares and the stock makes up 10% of the underlying index basis risk would arise in the hedge as the index may move by more or less than the portfolio being hedged in overall terms.

What is the Purpose/Rationale of investing in a Put Warrant?

The use of Put Warrants can be used to protect an equity portfolio or a single shareholding against a drop in the share price. This strategy is called "hedging" and involves taking a position in the warrants market opposite to a position already held in the investor's name. The aim of this technique is for any loss made in one market to be offset by a profit in the other. By buying put warrants, investors' intentions are that the profit the put generates if the underlying asset falls offsets the loss of the underlying asset. Should investors be mistaken and the market rises, the maximum loss on the put warrants is limited to the
amount invested.
Essentially, the objective of "Portfolio Insurance" is to achieve a high return when financial markets perform well and mitigate against negative returns when these markets perform badly. Investor's in general are adverse to the risk of negative returns and this strategy effectively sets a floor for the underlying portfolio. This strategy is where the best result is in fact for the put warrant to expire worthless. Ideally the investor would prefer to see the share price or the portfolio as a whole rise significantly and for the protection to have been unnecessary. The investor still enjoys the benefit of the rise in the share price and has lost only the cost of the put option.

Like all forms of insurance, the investor wants the protection offered by the institution, but in the end hopes it will be unnecessary.

Investors need to realise that this strategy is appropriate for shorter time periods where there is an expectation of a share price decline. If an investor wanted to maintain protection over a 12 month period for a stock holding it would be reasonably expensive. Additionally if an investor's view on a stock is negative on an ongoing basis then there is little reason to keep holding the stock in our opinion.

Before we at Logical Financial Management are in a position to make any formal recommendations to our clients we would need to consider issues such as: current pricing; Scenario Analysis; time frame for investment; cost of transaction; implementation and settlement procedures.

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