A listless stock market where the blue chips with high liquidity are hardly seeing trading volatility, has given rise to the issuance of call warrants on counters that are generally illiquid.

This is against the norm where investment banks generally issue call warrants on big cap stocks with high liquidity to minimise disruptions to the underlying stock.

In this respect, recent issuances of call warrants on stocks that are illiquid have somewhat correlated with sharp volatility on the underlying counters, catching the retailers off guard.

A case in point is the sharp movements seen in Datasonic Group Bhd since the issuance of call warrants on the stock.

Call warrants, issued by third parties are largely catered for investors wanting to take a short-term position on a company but not willing to fork out large sums of investment outlay for its mother share.

The call warrants are issued at a fraction of the share price of the mother share and tenure is between six months to one year.

The settlement is through a strike price and the issuer normally hedges against any possible losses by having a fair idea on the valuation of the underlying stock. If the stock is over-valued, the assumption is that the market will sell the stock and the issuer will be hedged.

However, if the underlying stock is illiquid, it tends to distort valuations.

“For companies that are illiquid, it is unreasonable to expect the issuers to be able to hedge themselves effectively because there is limited buying or selling in the open market to reflect the true value of the stock,” says Alan Voon, a warrants specialist.

So in such instances, Voon says one can only deduce that the issuer really understands the fundamentals of the underlying stock well and is also aware of the parties holding the shares.

Issuers of call warrants generally make money by selling the warrants at a premium.

Let’s look at IT company Datasonic which had an estimated free-float of about 36% in December.

Its share price has jumped more than 1000% since it got listed in September 2012.

Such strong interest had prompted Ambank Malaysia Bhd to issue a call warrant on the company with a conversion ratio of six call warrants for one Datasonic share.

The call warrants began trading on March 25.

On April 4, Datasonic shares plunged 22.6% to close at RM3.64 after an intra-day low of RM3.30, which was its maximum daily downside limit. It has seen some volatility since then and at yesterday’s close was RM3.62, up 16%.

The call warrants have also experienced volatile swings going up to as high as 63 sen and now at 30 sen, largely as a result of market-making by the issuer. Retailers who are not sophisticated enough are likely to have had their investments “burnt”.

Same goes for the warrants of condom maker Karex Bhd which were recently listed. Both warrants have seen a deep plunge to below 20 sen after trading above 30 sen earlier.

Voon says for a counter that is illiquid, the suitable option for issuers is to create more volatility so that it can sell the warrants at a higher implied premium.

“I see this as part and parcel of the warrants issuance business and retailers should not buy these instruments if they don’t understand the rules of the game.”

He suggests that authorities could require issuers to disclose their buying and selling of call warrants on a daily basis, which should give investors willing to take a chance a fairer chance to speculate.

“But I don’t think there is anything wrong from a business perspective for the issuers, as they are just finding ways to increase revenue.”

From an issuer’s perspective , it is easier to make money from new stocks with higher volatility as speculators tend to be attracted to such stocks.

“As long as these stocks meet the minimum market capitalisation of RM1bil for issuance of call warrants, there are opportunities for issuers to make money,” Voon says.

Still, if retailers continue to get hurt, this trend of issuing call warrants on illiquid stocks may have to take a setback, he adds.

An investment bank familiar with the issuance of structured warrants (SW) of which call warrants are a part of, says the instruments are usually issued via the direct listing method to allow all investors the same opportunity to participate in the respective issuances.

The SWs will be sold directly to the investors in the open market from the listing date throughout the tenure of the SW.

It disagrees that there is a “pump and dump” scenario in the market at the moment, saying that any such trend would be damaging for both the investor and the market.

“Regionally, most issuers would be careful to carry out their market-making obligations as it doesn’t make sense to engage in short-term issuance behaviour versus the long-term development of the market,” it says.

It does not discount the fact that there have been a few “high-profile” issuances lately that attracted overwhelming trading interests especially on the first few days upon their listing.

“This could have led to the “pump and dump” perception as high demand from investors coupled with upside momentum on the underlying stocks caused large trading volume and ascendant pricing which, thereafter, corrected somewhat.”

However, SW investors are typically traders and trade in and out of the SWs fairly quickly, sometimes even doing intra-day trades, so SW issuers are also market-makers to facilitate that, it notes.

“Issuers also have regulatory obligations as market-makers to provide bid and offer prices for the SWs in order to promote liquidity in the SW market.”

It notes that the SW market in Malaysia is considered fairly mature, having started about a decade ago and competition has increased as there are now six SW issuers in the market, creating stiff competition among the issuers which, it notes can only be beneficial to the investors with regards to pricing.

Like Voon, the investment bank believes that it is important that investors understand the mechanics of SWs and their pricing parameters.

“One key point to note is that SWs are trading instruments and not “buy-and-hold” investment products and thus are not suitable for certain investors with long-term investment horizons.”

Source: The Star