Wednesday, July 30, 2014

Investors, beware of conversion ratio in warrants

This article appeared in The Edge on Apr 28, 2014

I was intrigued by BFM’s 9.30am Wednesday show with Salvatore Dali on the 2nd of April.  It was about warrants, specifically the frustration around the conversion ratio in the Datasonic call warrants. I would like to take this opportunity to deliberate further on this subject to alert investors, especially novices, about the conversion ratio in warrants.

When we speak of warrants, we are frequently concerned about the moneyness of the warrant (i.e. its exercise price vs. the underling share price), the time to maturity and the volatility of the underlying share price. We expect market players to react to these key parameters, which result in the warrant price in the market. However hidden somewhere in the term sheet is the conversion ratio of warrants, which if missed by investors, will lead to an inaccurate expectation of the profits upon settlement. The conversion ratio is the number of warrants needed in order to buy (or sell) one share. Therefore, if the conversion ratio (warrant : share) to buy a share is 3:1, the holder needs three warrants in order to purchase one share.

In this article I wish to explain the logic for having conversion ratios in certain kinds of warrants. This is followed by a worked out real life example showing how the profits and gearing of warrants
could be easily misunderstood when the conversion ratio is not 1 warrant to 1 share.

The logic for conversion ratio in detached company warrants issued with bonds
It is quite usual for companies to issue bonds with detached warrants. The possibility to profit from the warrants serves as a sweetener for the investor, and enables the bond issuer to pay a lower coupon. Investors that wait until the maturity date of the warrants may exercise and convert them into shares.  The exercise price that they pay for the warrants are share proceeds for the company, which is usually projected as positive cash flow and part of the bond issue exercise. In this circumstance, the company may set a conversion ratio (warrants : shares) to compute the amount of dilution the company is prepared to endure along with the expected cash flow it needs to receive.
However the above argument is not relevant for warrants that are issued by third parties (investment banks), known as “structured warrants” in Malaysia. These warrants have no connection to the company. The proceeds from the issue price of the warrants goes to the issuer (investment bank) who should use the proceeds to hedge (or cover) its risk so as not to be affected if the underlying share’s price moves either way.

An example
Below is the example of the Datasonic call warrant issued on 24 March 2014.

Call Warrant price
(on 16 Apr at 11am)
Exercise Price (per share)
Conversion ratio
Expiry date
Mother share price
Premium to share price
0.20
3.72
6.00
12.01.2015
(271 days)
2.83
73.85%
* Note

* Note
Premium = (Warrant price + Exercise price – Share price) / Share price
Premium = (0.20 x 6 + 3.72 – 2.83) / 2.83

This call warrant is out-of-the-money, as its exercise price is at RM3.72 whilst the share price trades at RM2.83. Looking at just the face value of the warrant, it seems really cheap to be trading at 20 sen and could be a bargain! Experienced players will tell you to look again, especially at the conversion ratio of the warrant, which is rarely visibly displayed in newspapers and websites. The investor has to go a step further and multiply the warrant price by the conversion ratio to make a fair comparison with the share price.

If this warrant was issued at a conversion ratio of 1:1 , the warrant would actually be trading at RM1.20. The investor now might have a different view on whether this price is fair, looking at its properties, mainly its time value of 271 days before maturity and the volatility of the underlying share.

At the maturity of the warrant, if an investor ignores the conversion ratio or assumes the ratio to be 1:1, he may greatly underestimate his potential profitability upon cash settlement. Upon cash settlement, profits, if any, will be divided by six, as in the formulae below:

Cash Settlement = Number of call warrants x (Closing price – Exercise price)
            x  1 / conversion ratio

Besides profitability, the perception of gearing can also be confusing warrants with high conversion ratios. A simple gearing ratio is calculated by dividing the share price by the warrant price. In the above example, if the investor overlooks the conversion ratio, he would compute the gearing to be 14.15 which implies holding one warrant is equivalent to holding 14 shares. In actual, his gearing is only 2.36.


Transparency in displaying the conversion ratio for warrants
Judging the severity of the conversion ratio and how it impacts investors, it is disheartening to find that the Exchange and business news do not display the conversion ratio transparently. Even some brokers do not display the conversion ratio directly. In my opinion, the conversion ratio should be displayed right next to the warrant price.
Conclusion
I cannot figure out exactly why a conversion ratio is present in warrants issued by third parties. Could it be done so as to make a warrant price seem coherent with other warrant prices, which are usually in minor sen figures?
Whatever the reason, I would again caution investors not to miss the conversion ratio when trading warrants, for the consequences could be quite dreadful !


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