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Some thoughts on warrants...

  1. 328 Posts.
    Hi King Louie, et al,

    It is often thought that the issuer somehow manipulates the price of the underlying to below the strike in order to reduce the risk of the warrants finishing in the money and being exercised or paid out. This would not be the case if the issuer hedges its derivative position.

    Assuming that Macquarie Bank is hedging its short call position using traditional methods, it would have bought HDR in accordance with the hedge (delta) ratio when the warrants were issued, and it will be buying HDR as delta increases (price of HDR up), and selling as delta decreases (price of HDR down).

    Whether an issuer sells calls or sells puts, it will be short volatility. Macquarie Bank is hoping to make its money through the sale of warrants at high implied volatility (reflecting through to high premiums)... selling volaility high ..., and trading the underlying which has a lower historical volatility... buying volatility low. Presumably, it has no directional view on HDR, and strips out the directional risk by delta hedging. Theoretically the warrants position is offset by the physical position (... for small changes in the price of the underlying). It's called replicating the option in the underlying.

    Opposed to short volatility players like Macquarie Bank, are the long volatility players, who, from an initial short (for bought calls) or long (for bought puts) position in the underlying, will be buying the underlying when the price falls and selling when the price rises. A warrant holder is long volatility... hoping, among other things, that the volatility (hence premium) goes up.

    Pin risk is the risk to an issuer that the price of the underlying will become pinned to the strike price. The call-warrant issuer wants to make sure that it has enough underlying on hand should the warrants finish in the money and be exercised. At the same time it does not want to be left holding some else's baby should the warrants finish out of the money. A put-warrant issuer wants to have short sold position in the underlying only if there is a chance that the warrants will finish in the money.

    "In the Australian market, for instance, the hedge trading of option traders can tend to
    force, even quite liquid, stocks towards the strike of a large open interest in the option
    market on the days before expiry. This tends to significantly exacerbate pin risks, by
    forcing stocks toward artificial levels from which they can quickly rebound on the day
    after expiry as aggressive hedge trading suddenly ceases. In this situation we must be
    particularly mindful of the behaviour of other traders, it is common for significant
    turnovers to be generated as competing groups of traders tussle to force the market
    above or below the strike. The unwary trader can become caught in this maelstrom
    unless she has a solid grasp of the directions and aspirations of the various large
    (A Brief Introduction to Option Theory and Trading by Dr Dominic Verity.

    I'm not sure if this situation could ever eventuate in a stock like HDR with just two call warrants. I imagine the sole opposition to Macquarie Bank would be the long-side directional traders hopefully buying low and selling high.

    For a brief period, HDR was on the list of Approved Securities for short selling. As of Friday, 20 Sept, it has been removed. In any event, restrictions on short selling, would mean that most, if not all, warrant holders are not pure volatility traders, but speculative directional traders looking for leverage. In this market, there are just no options for long volatility traders who theoretically would tend to stabilize the forces of the short volatility players.

    So, this leaves us with a one-sided hedging game... Macquarie Bank... buying HDR high and selling low... The danger to Macquarie Bank is that this re-hedging would tend to exaggerate the price moves of the underlying, particularly for low liquidity stocks. This is the opposite of what Macquarie Bank wants... it is looking for low volatility, less need for re-hedging and some certainty as to whether or not the warrants will finish in or out of the money.

    Just getting away from theory and speculation as to what may or may not be going on... my reading of the offering circular mumbo-jumbo is as follows... correct me if I am wrong.

    "Automatic Exercise" will only occur, for example, on HDRWMA if the average weighted share price of HDR from 2 til 4pm on 28 Nov equals or exceeds the strike price by 5%... that is, equals or exceeds $00.7875. (Sounds crook?) In this case, Macquarie Bank will pay warrant holders an Assessed Value Payment of 90% of the intrinsic value calculated as the difference between the strike price and the average weighted share price on the five trading days AFTER expiration. Now that sounds crook! Please correct me if I am wrong! A warrant can finish in the money and you could get paid zilch when the price falls as a result of the warrant issuer unwinding its hedge over the five days following expiration. Throw the text books out the window... this is not a derivatives market! Its a scam!

    Calm down... it's a leveraged directional market for the punters.

    Not sure if this useful... just some thoughts.

    Best of luck.

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