A case study of company warrant of BIMB kcchongnz

A case study of company warrant of BIMB kcchongnz

Recently many companies in Bursa carry out fund raising of right issues for debt reduction, business expansion, acquisition etc. To entice the existing shareholders to subscribe to the right issues, detachable warrants were purported given free.

Company warrant is a derivative instrument, like a call option, which gives the holders the right, but not an obligation, to subscribe for new ordinary shares at a specified price during a specified period of time. Warrants have a maturity date (up to 10 years) after which they expire are worthless unless the holder had exercised to subscribe for the new shares before the maturity date.

Why invest in company warrant?

Because the prices of warrants are low, and hence the relative much lower investment outlay, the leverage and gearingthey offer is high. This means that there is a potential for larger capital gains. Warrants generally exaggerate share price movements in terms of percentage change, and hence a perfect security in a bull market.

To be fair, warrants also experience outsized declines in a falling market, or even a total loss when the warrant expires out-of-the-money. However, as the investment outlay is low, there is a limit of that loss.

A holder of a warrant does not have any voting, shareholding or dividend rights. The investor can therefore have no say in the functioning of the company, even though he or she is affected by any decisions made.

Punters should also be aware that warrant trading can be tricky because many don't have a lot of liquidity. Before buying, the cardinal rule is that investors have to like the company, not just be looking for a quick trading profit.

Hence investors who are interested in investing in warrants should buy warrants only on stocks they are confident about. Furthermore, you should invest only in warrants with a long expiry date, say at least two years of remaining life, enough time to allow a bullish scenario to play out. Finally, investors should insist that any warrant they buy offers leverage that will result in a high percentage rise say at least double the move in the underlying share.

Basic Pricing of Options

Investing in company warrant is similar to investing in a stock, or in fact it is the same as buying anything. What is the appropriate price to pay for estimated value of the warrant?

The two components of the value of the warrants are the intrinsic value and the time value. The intrinsic value is the difference between the underlying's share price and the exercise price. Specifically, the intrinsic value for a warrant  is equal to the underlying price minus the exercise price. Any premium that is in excess of the warrant's intrinsic value is referred to as time value.

Many people investing in warrants only look at a couple of things. First is the premium, or the cost of owning the warrant measured by:

Premium = Warrant price + exercise price - underlying share price, or

Premium % = (warrant price + exercise price) / underlying share price -1

The highly the premium, the higher the warrant price appears to be. Normally in an efficient market, warrants are quoted at very high premiums in tenths of percentage points, or even multiple times, depending on some factors described below.

The other factor is the gearing measured by:

Gearing = underlying share price / Warrant price.

The higher the gearing, the more attractive is the warrant as the more exaggerated the gain would be. However, just looking at these two considerations alone is a little too simplistic.

Factors influencing and the pricing of warrants

The six major factors influencing the price of options are:

1. underlying share price,
2. exercise price,
3. expected volatility of the underlying share,
4. time to expiry,
5. interest rate and
6. dividends.

Warrants with high underlying share prices, low exercise prices of course would generally be higher priced as they are generally are or close to in-the-money. The more time to expiration, the greater the time value of the option. In general, investors are willing to pay a higher premium for more time, since time increases the likelihood that the position can become profitable. Time value decreases over time and decays to zero at expiration.

 Volatility of the share price movement also command a higher warrant price as it has a higher chance that the underlying stock prices can go up higher, and hence the better payoff for the warrants. The volatility of the underlying share price plays a very big part in the pricing of its warrant. A warrant trading at a high implied volatility is considered as expensive.

High dividend yield for the underlying stock is a damper for warrant holders as they are not entitled to the payment. On the other hand, if company constantly has been engaging in share buyback, it is good for warrant holders as the price of underlying would move up due to share buyback.

Notice that the gearing does not physically come into the pricing consideration. It merely amplifies the gain or loss. But in real life, investors do pay higher price for a similar warrant.

For more information about options and their pricing using the Black-Scholes Option pricing Model , please refer to the appended link.

http://www.investopedia.com/university/options-pricing/

A case study on BIMB Wa

BIMB Holdings Berhad is engaged in the Islamic banking, Takaful and others such as investment holding, currency trading, ijarah financing, stockbroking and unit trust. Its share price has dropped from a high of closed to RM5.00 six months ago to RM4.23 now, mainly due to its poorer performance for its final quarter result ended 31^st December 2013 resulting from a one-off tax charge of dividend income. Its full year result remains unchanged with earnings per share of 24 sen.

With its recent acquisition of 49% equity interest in Bank Islam, it is expected that there will be substantial increase in earnings in the future.  CIMB gave it a target price of RM5.45 a month ago.

BIMB and its warrant, Wa closed at RM4.23 and 66 sen respectively on 28^th March 2014. The exercise price of Wa is RM4.72 and the expiry date is on 4^th December 2023, or in nine and a half years time. The warrant is hence way out-of-the-money with zero intrinsic value. The premium now is 27% [(0.66+4.72)/4.23-1].  The value of Wa is purely in its time value, a value which is considerable due to its long expiry date. The gearing is 6.4 times (4.23/0.66) which is reasonably high and hence attractive. Hence Wa appears to be a good alternative in investing in the business of BIMB.

Black-Scholes Option Pricing

With the underlying share price at RM4.23, exercise price of RM4.72, 9.7 years to maturity, a dividend yield of 1.7%, risk-free rate of 4% and a historical volatility of BIMB at 29.5%, the option value of Wa is RM1.41. This shows Wa at 66 sen, is apparently trading at 53% undervalued.

The implied volatility, by forcing the warrant value equals to its market price, is only 12.3%, a relatively low value which signifying a cheap price for Wa.

Payoff for BIMB warrant

Table 1 below shows the payoff for Wa for various price of BIMB before expiry of the warrant.

Table 1: Payoff

Uly Price	4.00	4.23	4.50	5.00	5.50	6.00	6.50	7.00
BIMB	-5.4%	0.0%	6.4%	18.2%	30.0%	41.8%	53.7%	65.5%
Wa	-100.0%	-100.0%	-100.0%	-57.6%	18.2%	93.9%	169.7%	245.5%

If the price of the underlying share does not move above RM4.72, the exercise price, when Wa expires, it will be worthless. Your initial outlay is the limit of your total loss. However, if BIMB share price moves up by 66% to RM7.00, Wa can be exercised for a gain of 246%, about 4 times more than the gain in the underlying share. Figure 1 below depicts the payoff at different price of BIMB.

Figure 1: Payoff for underlying share and warrant of BIMB

Conclusion

BIMB Wa, with a long time to expiry,  is trading at an undemanding valuation in terms of premium of 27% and implied volatility of just 12.3% compared to its historical volatility of 29.5%. Furthermore, it has a high gearing of 6.4 times which would greatly amplify the gain if the underlying share price goes up before the expiry date.  Hence, if you believe in a company like BIMB as an investment, Wa is definitely an excellent buy.

K C Chong (30/3/14)