Feature Stories | Aug 11 2006
By Greg Peel
Firstly, do not be worried by the term “derivative”.
Derivative products have been around for decades on every financial instrument imaginable and the only reason they get bad press is because very few people in the world properly understand them. Rarely does one read about benefits of derivatives, as the sum total of people in the standard press that understand derivatives would be zero.
People who use derivatives successfully do not make a song and dance about it. While derivatives can be used to enhance risk they can also be used to reduce risk. Those who go down the former path can get themselves into trouble through (1) ignorance and (2) greed. Consider the following two examples:
Sons of Gwalia gold company. Bankrupted when a gold hedge book turned into a punting book. The traders were greedy and the board was ignorant.
National Australia Bank. Lost millions on forex derivative trading when greedy traders tried to hide their losses. Internal risk managers were criminally ignorant (but escaped blame).
Now try this one:
BT Funds Management, 1987. BT’s equity fund was the only large public fund on the market that finished square while every fund around it lost millions overnight in the crash. It did so by investing in insurance through derivatives. BT’s reputation soared and it dined out on its foresight, and its subsequently increased funds under management, for years after.
The moral to the story is: do not dismiss derivatives out of hand if you don’t have a strong understanding.
Having said that, now consider that the dividend yield on a stock can be enhanced through the use of derivatives called “instalment warrants” which are no less risky than investing in a stock in the first place.
What is an “instalment warrant”?
An instalment warrant is a form of call option. A call option allows the buyer to buy stock at a predetermined exercise price at some time in the future. If, at maturity, the stock price is higher than the exercise price the holder will exercise the option to buy at that exercise price and thus show a profit. If the stock price is lower than the exercise price the holder simply walks away.
To acquire this right the option buyer must pay a premium. The amount of premium is a function of the odds of that option being exercised. The shorter the odds, the higher the premium. This has nothing to do with one’s view on the underlying stock. It is firstly a mathematical calculation of exercise price, time to maturity etc, and then a guesstimate from the seller of the level of volatility in the market. The more volatile a market, the greater the chance a stock will reach its exercise price.
There are two types of simple call option traded on the ASX. The first are options issued by a company which, when exercised, will be settled by new stock issued by the company (affecting dilution). These are known usually as “company options”.
The second variety are known as “exchange-traded options”. These are not issued, but allowed to be “created” when bought and sold by the market, with the support of the ASX and the approval of the underlying company. ETO’s are exercisable over existing stock only and will not affect dilution. There is a limit as to how many ETO’s may exist over one company.
For all intents are purposes the two styles of options are identical in their behaviour. Yet the ASX imposes strict rules on brokers advising clients to trade in ETOs, and no rules on trading in company options. This is an incompetent oversight and should be dealt with. If you are advised to buy company options I would strongly recommend you get hold of a copy of the ASX rules that apply to trading ETOs and interrogate your broker accordingly.
The first Australian stock warrants were issued by Macquarie Bank in the early 1990s and many other issuers soon followed. The first stock warrant market-maker in the country was – me.
Warrants, in their basic form, are no different to call options, but are issued for longer times to maturity. They are exercisable over existing stock and thus do not affect dilution. They are issued by investment banks and brokers with the support of the ASX and the approval of the underlying company. A warrant issuer must always make a buy-back price in the market for a minimum amount on a minimum spread.
That’s the simple part. Since the first warrants were listed in this country there have been a raft of more complex warrant-based instruments listed that fulfil a range of investor needs and horizons. The ASX can provide an investor with all the relevant information, so I won’t go through them all here. I’ll just pick one.
The “instalment warrant” is a form of call option that acts very much like a typical share instalment instrument, such as those initially listed on Telstra (TLS). A typical instalment allows you to pay part of the share price now, and obliges you to pay the rest later or sell back to the market. This is a form of leverage, and you are hoping the gains on first instalment will cover the cost of the second.
An instalment warrant is similar except that you are not obliged to make the second instalment. Like a call option, you can choose to walk away.
To demonstrate the nature of an instalment warrant, I will choose a 15 year, 18 month reset warrant issued by ABN Amro over Adelaide Bank (ADB). The ASX code for this warrant is ADBIZQ. The reason I choose this one is that ABN has issued a report suggesting this particular issue is one which offers the opportunity for yield enhancement, and thus it provides a good opportunity to talk warrants.
This warrant works off a 50% instalment, which can provide the buyer with 50% gearing.
The 15 year maturity began in December 2005 but don’t be put off by the length if you are playing a shorter term strategy. These warrants began life as a 50% instalment, and they “reset” every 18 months, so you can play them as an 18 month option. Each 18 months the next payment is set at 50% of the share price again. You can choose to play on, by making the next instalment, and whether you are in debit or credit will depend on whether the share price has risen or fallen up to that point. Or you can choose to get out, in which case you will make/lose only the difference in value from the time you got in. (At any time prior you can sell the warrant back to the market).
The next instalment payment is due in July 2007. At the time of writing the stock was trading at $13.00 and the warrant was trading at $6.07. If the stock price goes nowhere between now and July, and if ABN’s dividend assumptions are correct (dividend policy is subject to change by the company), then the stock will yield 4.69% per annum (pre-tax).
If you hold the warrant over the same period your equivalent yield would be 5.65%.
The reason your yield is higher is because you have not paid for the stock in full – you’ve merely paid an instalment – but you still receive the dividends.
This is not a freebie. If you do the numbers you see the warrant will cost you $6.07 and your required payment would be $7.50 which equates to $13.57 when the stock is at $13.00. That $0.57 is the premium you are paying for your right to walk away, and the cost of interest. ABN is effectively lending you money by requiring you to only pay 50% of the stock price at each reset.
Because the dividend payments over the period are assumed to add to $0.61 you are already ahead. Grossed up for franking that figure is $0.87.
Of course, the Adelaide Bank share price may fall. But then this strategy already assumes you are happy to hold Adelaide Bank, if for no other reason than its yield, in the first place.
ABN Amro has set a 12-month target price for the stock of $14.15. If this proves accurate, the warrant holder can return 27.19% against a total stock return of 17.68%. If the broker’s prediction is accurate.
But wait, there’s more. Remember I said the $0.57 can be considered an “option premium” and an interest cost? Well in fact it’s both. $0.46 of the $0.57 is a tax deductible interest cost and the balance is the “capital protection” premium which is really the option part. The amount of that deduction you can claim depends on your own tax situation.
The obvious question here is “What does ABN Amro get out of it?” It may seem suspiciously a bit of a good deal. Well the answer is the premium and the interest. The interest they charge you will be more than their internal cost of funds (just like borrowing from a bank) and the premium they collect offsets the risk they will carry on the amount of Adelaide bank stock they will have to buy on your behalf.
They won’t buy the full amount, only a “delta hedge” equivalent, and they have effectively sold you a “put” option as well but that’s a story for another day and should not be something the investor need lose sleep over. Just trust me – ABN is still carrying a risk position, not an arbitrage.
Instalment warrants, and other warrant and equivalent instruments, offer the investor a chance to enhance yield in a time of rising interest rates. If you are interested in warrants, DO NOT DO ANYTHING BEFORE SPEAKING TO YOUR BROKER OR THE ASX, before you go barrelling in. These are derivatives, and they are complex. They are, however, no more dangerous than a stock itself. Just a little more complex to understand, that’s all.
