How do warrant issuers make money? Is it normally at the expense of the warrant investors?
Before addressing the questions, let us first tackle a long-lived market misconception. Many investors think that absolute warrant prices are where issuers’ earnings come from. Meaning, if an investor buys a warrant for $0.50 and sells it back to the issuer for $0.40 the issuer makes a $0.10 profit or vice versa. This is simply not correct. The main rationale for issuing warrants is not making money at the expense of warrant investors, instead its aim is to capture profit on the risk management of warrants sold. When issuers sell warrants they will normally buy shares or other derivatives to ‘hedge’ their position. Issuers will incur costs to do this and are then exposed to movement in the price of the underlying share / instrument. Even if hedged correctly, potentially they may still lose money.
A simplistic example helps to explain one of the ways in which issuers ‘hedge’. When an investor buys a call warrant from an issuer that call warrant should, all things being equal, increase in value as the share price increases. On this point investors may have the perception that this means the issuer will lose money. However, when an issuer sells a call warrant they will typically go into the underlying market and buy the underlying shares. Accordingly, if the share price increases, in theory, not only should the call warrant increase in value and the investor make profits but also the issuer should make a gain on their share holding. The converse is also true. That is, if the share price declines instead of increasing, all things being equal, the value of the call warrant should decline. Thus if the issuer is holding shares as a hedge the value of the issuer’s shareholding will decline. This example shows that warrants are not a ‘zero sum game’ which pervades as a common misconception in the market.
Despite the above illustration of issuers hedging with shares, issuers actually tend to focus more on “volatility hedging”, rather than the ups and downs in share price that retail investors tend to focus on. The volatility of a share, simply put, is how much the share price moves around and is expressed in a percentage: the lower the percentage figure the less volatile the share has historically been, the higher the more volatile. This volatility level is a key parameter in determining the price of all options and warrants. Issuers look at this percentage as a way to measure the value of options and warrants and when considering which options to buy as a hedge against the warrants they have sold. If they have sold a warrant that has an ‘implied volatility’ level of, say, 25% and they can then buy another option of similar terms at, say 23%, they would theoretically be making a ‘margin’, or profit. Sounds complicated but in essence this is a major way that issuers attempt to make profit rather than ‘trading against investors’.
It is not possible to explain the above process in a few words as it is quite a complex and dynamic system which requires an issuer to continually trade and hedge their position as they buy and sell warrants. Profitability and the respective risk management techniques of issuers are closely related. Generally, most issuers manage their risks in the form of a trading portfolio, which contains different derivative instruments such as, equity linked and capital guaranteed products, warrants, OTC options and underlying shares, each having different risk levels.
Remember, warrants are simply another financial product where it is in the product issuer’s interest for the investors to have a positive experience with the product. Therefore, many warrant issuers invest considerable sums in education, marketing and risk systems to help investors understand the nature and risk of the products in order that investors can make good use of the products and achieve their investment objectives.
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