What About The Issuers?

deborah said...
The HK china cover warrants hve really gone up a lot... I read comments of investors of local cw that they dont make money as the local market is perceived to be more controllable. My question is, with all the money that we hope to collect come maturity, wld it be a big dent on the income statement of the issuers?

greenbull said...
I am also curious of the fact that how it will affect the issuer whether the cws rise or fall in price? how do they get the extra cash to pay off the investors if the cw price goes up? i really hope someone will explain to new initiates like us. recently i bought ioicorp-cw and let it expire. I have still to receive the payout from them. i am supposed to get the difference in the mother and exercise price. would the return be more if i just sold the cw just before it expired? I am heavily involved in the H-shares cws, thanks to the recommendations by Salvatore. I sole some last few days but the price kept going up. I think i will just let it ride and watch them very closely. this is once in a life time opportunity to make bucks. the chances of making more far outweigh the unlikely possibility of losing all. i might even go in some of the laggards like sinopec, shenhua and cnooc.

hakiew said...
I think the issuer of the CW will do the following for risk management: 1) Keeping or trading part of the issues 2) Hedging by buying similar or more attractive options elsewhere

Comments - I have seen comments in chatboxes proclaiming the issuers of CWs as blood sucking tyrants, and that people should leave them alone, and that issuers are all locking in easy gains... etc... That is simply not true. In fact, issuing CWs is a pretty tough way to make money. There are a couple of houses who lost a bundle on the first few CWs because they did not hedge properly or even know what managing risks is all about. I had the opportunity to participate in the first big wave of warrants and convertible bonds as I was with one of the top 3 Japanese securities house in the late 80s. It was a madhouse, a lot things did not make sense, sometimes we were paying companies to issue bonds so that we can strip the warrants out to trade. We had to manage risks in a different way as it was a company's warrants. Managing risks in a call warrant or covered warrant is very different. A company issued warrant can be covered by just issuing shares whenever somebody wants to convert. An independent issuer has things very different indeed.

a) Can they lose money? Yes, issuers can and do lose a lot of money if they do not manage risks properly. E.g. you issue 10m Petrochina covered warrants convertible at HK15.00, and the market price was HK14.50 with a 6 month maturity. If it was 1 warrant for 1 share, you could price the covered warrant at a distribution price of HK$1.50. At HK$1.50, the premium would be 16.50/14.50 or 13.8%, with a gearing of 9.6x, very attractive and should have no problem placing out, though can probably place out at HK$1.70 even easily.

The issuer can cover their asses totally by buying 10m Petrochina shares prior to issuing the warrants (nobody really does that btw). Because that will only cover the upside risks. The issuer only gets HK$15m in IPO premium when selling the warrants, but you would have to cough up HK$145m to buy 10m shares. The HK$145m would be naked exposure, and you have to calculate the opportunity cost and exposure risk. Having the 10m shares can only cover your upside, but what if Petrochina shares drop by 20% in value come maturity date, that would be a book loss of HK$29m, totally wiping out the HK$15m premium.

If Petrochina goes up during the 6 months, you are safe and can sit pretty. Assuming a capital cost of 5% for the 6 months, the HK$145m purchase to hedge would have incurred interest expense of HK$7.25m. So in actual fact, its not a huge margin business for the risks to be assumed.

b) Dynamic hedging - Have some shares, have some covered on your books. This is the way to buy and sell volatility, sell when premium is high and vice versa. Its dynamic as exposure needs to be updated and careful monitoring is necessary. Some issuer do not sell all the proposed block during initial release, esp if they think it will be well received. Not to simplify things, there are also other instruments such as futures and options which can be used as imperfect hedges (close correlation in beta, but not 100%). Dynamic hedging is the preferred way to manage risks and also use limited capital exposure to maximise gains.

c) When do issuers make a lot of money? - Basically, the issuer locks in the premium on Day 1. The issuer has a comfort circle, which is issue price + conversions price = 1.50 + 15.00 = 16.50, as long as the warrant does not go beyond 16.50 on maturity they will make the difference. Naturally they will make even more when the warrants expire worthless.

d) For those who think that issuers will keep maybe 50% of supposed issue for themselves to sell later, and by that way will make supernormal gains - its a huge fallacy in thinking. Back to the Petrochina example, if say the issuer only sells 5m warrants on Day 1 at HK$1.50 = HK$7.5m, the issuer is selling at a premium of 13.8%. if the shares go up and the warrant reaches HK$3.60 after a few weeks and decides to sell the balance at HK$3.60, the issuer will get HK$18m. That looks to be "profits" but its not. When the warrant is HK$3.60, the actual premium may have dwindled down to 5% only, so in actual fact the second batch of Petrochina was issued at a huge disadvantage to the issuer!

e) As for hedging by buying other covereds at lower premiums, that may work but only if the maturity dates sync up. Plus its a sissy way to run a business, as you only piggyback. That kind of team will never amount to much.

Anyone wants to start a CW team, let me know, but its not going to be cheap... lol.