Trading in Warrants or Options (Part 2)

“As a stock-market participant, I have always thought that the covered warrants issued by financial institutions should track the movements of the underlying instruments closely.” This was the opening remark made by a Straits Times Forum page writer on 21 May 2007. He went on to explain why he made this remark.

The warrant in particular was STI3000SGAePW70628, a Put Warrant issued by the market maker Societe Generale (SG), a French Bank. The price movements for the stated period were as follows:

May 10: STI closing at 3,469; Warrant Price was $0.065

May 11: STI closing at 3,446; change – 23; Warrant Price was $0.065; (unchanged)

May 14: STI closing at 3,501; change +55; Warrant Price was $0.045; (-$0.02)

May 15: STI closing at 3,475; change -26; Warrant Price was $0.04; (-$0.005)

STI3000SGAePW70628 Put Warrant gives the holder the right to SELL the underlying security which is the STI 3000 (an index and not a stock) at a strike price of $3,000 at the end of maturity date of 28 June 2007. Investors in this Put Warrant are predicting that STI will drop to the level of 3,000 or below on 28 June 2007.  (Of course there are other investors who hold the opposite views on the STI index hence will be more interested in the CALL warrant instead or adopt an investment strategy that is opposite to the former.)

The Forum writer then made the observation that when the STI dropped, it should bear good news for the Put Warrant buyer and the warrant price should appreciate. Instead, it remained unchanged on May 11 and it actually decreased on May 15. On May 14, when STI increased by +55, the warrant price promptly depreciated by 30% to $0.045 (which was in the right direction but the warrant investor suffered more in monetary quantum term.) He felt that the warrant issuer has not discharged its fiduciary duty properly when playing the market maker’s role.

This prompted a rebuttal from Societe Generale when the Director of the Equity Derivatives wrote to the Forum page on 23 May 2007. The main point in his letter is that the PRICE of the underlying security (in this case the STI index) is just but ONE of the factors that influence the Put Warrant pricing. The other factors include – Days to maturity; Implied volatility; Interest rate; Dividend. It is thus possible that a movement in the STI in one direction may not result in STI Warrant moving in the expected direction, as the other factors may result in a move in the opposite direction. He went on to explain in technical terms why the warrant pricing behaved the way they did on those 3 days.

Dr Mark Mobius, the investment guru and the Managing Director of Franklin Templeton Investments, recommended that if you are risk-averse with your investment, you should stay away from derivatives such as options or warrants. This appeared in the Weekend TODAY dated 26-27 May 2007. Warren Buffet oft-quoted statement that “if you do not understand the financial instrument, do not invest in it”, is something to take heed before we risk money on the investment.

Written on 5/26/2007 4:03 PM

Copyright © 2007, the author known as LKT in Singapore.

The material presented is intended to be general and written in layman’s language as much as it is possible. The author shall not be liable for any direct or consequential loss arising from any use of material written. Please seek professional advice from your financial advisor or financial institutions on material written covering financial matters.

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