Structured warrants issued by banks have become a world-wide success story in the last couple of years. Despite restrained stock markets, the turnover in structured warrants as well as the number outstanding has increased year on year. In Hong Kong, structured warrants account for over 15% of the daily traded turnover on the Hong Kong Stock Exchange, and in Singapore market participants are starting to see structured warrants gaining similar momentum.
The listing rules for warrants in Singapore were amended in January 2003. Under the rules, warrants are no longer required to be placed upfront to investors, and warrant issuers typically appoint designated market makers for their warrants.
At the beginning of last year, there were only five structured warrants listed in Singapore. By the end of March this year, there were 239 warrants outstanding on 40 different underlyings, from five different issuers.
The turnover in the Singapore warrant market surged over 50% in the first quarter this year comparison with the whole of last year. The market saw SGD2.29 billion (USD1.38 billion) of traded value in warrants. The traded value in structured warrants was also 16 times higher than the one for company issued warrants during that period. Even more impressive is the percentage of the structured warrant turnover compared with the overall stock exchange turnover. The warrant turnover in 2004 represented less than 1% of the overall securities trading in SGX-ST but this percentage increased to 5% this year. The average daily turnover in warrants is now around SGD38 million.
Like any other market, only a selected number of warrants on these 40 different underlyings are really actively traded. In Singapore, the most actively traded underlying for warrants in Q1 were NOL, followed by Cosco, CapitaLand, Datacraft and Creative. They accounted for 40% of the traded value in Singapore warrants. The top 14 underlyings account for around 75% of the total warrant turnover. Naturally, the most traded warrants are all related to these underlyings. For instance, a covered warrant on Datacraft (DATACRAFT DB ECW050725) contributed over SGD140 million to the overall turnover in Q1 which was more than the entire turnover of all company listed warrants in Q1 in Singapore.
With the populartity warrants have enjoyed in Singapore, they are back on investors' radar. Unfortunately, there are still misconceptions about structured warrants in Singapore.
Company Warrants, Structured Warrants And Listed Options
Company warrants and structured warrants are listed on the SGX. Company warrants are issued by companies typically for financing reasons. Structured warrants are issued by banks and third parties (issuers) to give investors leveraged trading and investment products on different underlyings. These underlyings may include stocks, indices, currencies or commodities. Due to this variety of underlyings, exercise prices and different maturities, structured warrants have become the preferred warrant type for private investors.
In Singapore, 5% of the warrant turnover in Q1 came out of company warrants and the other 95% from structured warrants. In Hong Kong and Germany, the two largest markets for warrants, 98% of the turnover in warrants is from structured warrants.
For options as a trading tool, financial markets distinguish between listed options standardized by exchanges and structured warrants tailor-made by banks. But in reality, options and structured warrants have a lot in common. Indeed, structured warrants are often seen as complementary to the options market.
Standardised option contracts are listed on derivatives exchanges, such as SGX Derivatives Market, Eurex or the Chicago Board Options Exchange. These options are standardized with respect to their underlying, lifetime, exercise convention, margin requirements and trading procedures. The main benefit of standardization is transparency. However, this high degree of standardization can be disadvantageous, particularly in view of the individual, rapidly-changing requirements of each market participant. Banks acting as issuers exploit this disadvantage by offering structured warrants. These are securitized options, listed on a stock exchange and can be traded like any other security. Each warrant has a securities code and is issued on the basis of a listing document which defines the tailor-made option terms (lifetime, conversion ratio, etc.) in detail. Structured warrants are always offered by the issuing bank, which is free to customize all parameters of the securitized option, including the underlying instrument, size, exercise price and lifetime.
The pricing process for standardized options is generally supported by bank traders acting as market-makers, quoting prices in the exchange trading system. While this process works reasonably well for at-the-money options, the availability of prices for out-of-the-money or deep-in-the-money options is usually rather scarce. Investors are often faced with a lack of prices, and must separately request a quote.
Structured warrants, in contrast, benefit normally from a continuous quotation across all outstanding products, ensuring that there is always a price, regardless of whether the warrant is out-of-the-money or deep in-the-money. Hence, there is no need for quote requests.
The strong focus of the structured warrant market on retail investors is also evident in the wide selection of media where price data is available: real-time price on the internet or daily newspapers.
Designated Market Maker For Structured Warrants
Most market participants are aware of the importance of sufficient market depth and focus on it in their trading decisions. However, contrary to popular perception, this is not always an important factor in relation to structured warrants listed on the SGX. Each issuer of structured warrants typically appoints a designated market maker for its structured warrants throughout trading hours. This means that the designated market maker continuously quotes binding two-way (buying and selling, or bid/ask) prices on the exchange, and investors can trade the products at these prices. The ask price is generally a few cents above the bid price. Designated market makers, therefore, ensure that these instruments are always tradable.
Any issuer of structured warrants who wants to build and maintain a long-term reputation in the structured warrants market simply has to be active as a designated market maker to ensure its credibility and build up a brand as reliable issuer. But in addition to this marketing issue, issuers also enter into a legal commitment to quote tradable prices on a continuous basis. When applying for a listing for structured products on the SGX, issuers must undertake to comply with the rules and regulations of the exchanges, which include a continuous quotation obligation if they appoint a designated market maker for their structured warrants.
In contrast to equities or bonds, where the market liquidity has an immediate impact on the exchange price of the respective instrument, the pricing of structured warrants is not usually dependent on traded volumes. As soon as an investor buys a structured warrant from or sells a structured warrant to the designated market maker (as an agent of the issuer), the issuer starts to hedge its position to be market neutral. If an issuer of structured warrants runs out of inventory (having completely sold out), it may apply to the SGX for approval to issue further warrants, so that the total supply of the warrants is increased. This is why the price of the warrant does not typically depend on supply and demand. It is very important to understand that an issuer of structured warrants does not usually speculate against the investors. Issuers usually adapt their pricing to the price development and volatility of the underlying instrument, and to the warrant's lifetime.
The size of the bid/offer spread can, of course, be affected by the market liquidity of the underlying: in the case of a wider spread in the underlying instrument, issuers are faced with higher hedging costs which they will factor into the pricing of related structured warrants. Having said that, issuers define a maximum bid/offer spread when listing structured warrants.
In conclusion, the pricing of a structured warrant is typically independent of how actively traded a particular warrant is.
With the success that structured warrants have achieved in Singapore for Q1 of 2005, it is worth asking where the Singapore warrants market stands globally. Compared to Hong Kong--the biggest warrant market in the world--Singapore is 15 times smaller in terms of traded value. But we can be sure if the market conditions continue to remain favorable in the successive quarters, Singapore could give Hong Kong a run for her money.
This week's Learning Curve was written by Thorsten Michalik, director and head of warrants in Asia at Deutsche Securities Asia.
