How To Do It: Warrants deserve closer scrutiny

As the Gulf-based expatriate looks at ways to enhance his portfolio, there is no doubt that equity warrants deserve closer perusal.

However, the intrepid investor will have to be aware that this form of investment comes with the usual warning that the higher potential returns brings with it higher risk.

There are two types - call warrants and put warrants. When a call warrant is purchased, the right, rather than the obligation, to buy a particular share is bought at a specified price. This is in contrast to a put warrant that gives the right but not the obligation, to sell the underlying equity at a certain price.

Such investments will not be for the average punter but would be best suited for the investor who knows what he is doing and understands the mechanism of this type of investment vehicle. The nature of this type of warrant requires that the investment is continually monitored and reviewed.

Their value is based on the underlying shares on which they are issued. The purchase price is normally a fraction of the underlying share price and is in fact a premium paid to buy the equity. It gives the savvy investor the opportunity to attain any profit derived from the share price rise for a much smaller outlay.

Such warrants are normally issued by banks and similar financial institutions who determine the warrants' specifications such as its exercise price, expiry date etc. The exercise price is the amount that needs to be paid for the warrant - the right to buy the underlying shares.

The expiry date is the last date on which a call warrant can be exercised and is usually set for three months to one year down the track.

To elucidate the point further, suppose Al Gore LLC issues warrants. Assume the exercise price is Dh500 and the warrants are Dh25 each expiring on June 30 2003 with the current share price being Dh500.

Investor A buys 1,000 shares and his outlay is Dh500,000 (Dh500x1,000) whilst Investor B buys 1,000 warrants for Dh25,000 (Dh25x1,000). If the share price were to rise to Dh600 and both investors decided to divest themselves of Al Gore LLC paper, both investors would make a profit.

Investor A would have had a 20 per cent return on his Dh500,000 investment - he sold his 1,000 shares which cost him Dh500 a share for Dh600 making a profit of Dh100,000.

However, Investor B would have made a profit of Dh75,000. He bought 1,000 warrants at Dh25,000.

On exercising his warrant, he bought the 1,000 Al Gore shares for Dh500,000 (the exercise price) and then sold them for Dh600,000. Investor B has made a whopping 300 per cent profit.

It does not take a rocket scientist to see why warrants can be a useful investment vehicle. For a relatively small outlay, it is possible to earn a big profit in percentage terms. As a hedge factor, warrants can be a useful vehicle for the wary investor.

So far so good but there has to be a downside and this is the fact that if the equity price were to fall, the converse will apply and the holder will end up not exercising his option; this will result in losing all the money paid to purchase the investment in the first place. Bear this in mind before rushing out to invest in this sector - it has been the ruin of many a poor man.

The writer is managing director of Al Ghaith & Co, public accountants, and financial writer.