Frequently Asked Questions 
17/06/2014 
 

Chapter 6 Products - Securities Market

6.5

Warrants

 

General Features


6.5.1    

What are warrants?

There are two types of warrants: equity warrants and derivative warrants.

Equity warrants are issued by a listed company.  They give holders the right to subscribe for equity securities of the issuer.  Equity warrants are often issued together with new shares in IPOs, or distributed together with the shares acquired for any dividend payment, bonus issue or rights issue.  Equity warrants have a life of one to five years.  When these warrants are exercised, the listed company will issue new shares to their holders and collect extra capital.  The issuer of a warrant must specify whether it is settled by cash or by physical delivery of the underlying assets. 

"Derivative warrants" fall under the category of derivative investment instruments or structured products.  They have a life of six months to five years.  The underlying assets of derivative warrants include ordinary shares, market indices, currencies and baskets of shares.  Derivative warrants are issued by a third party, generally an investment bank, independent of the issuer of the underlying assets.  The issuer of derivative warrants may not be the issuer of the underlying assets but should hold or have a right to hold the underlying assets.

Derivative warrants can be linked to a single security or a basket of securities, stock indices, currencies, commodities or futures contracts (like crude oil futures).  Almost all derivative warrants currently traded in Hong Kong are cash-settled.  Warrants linked to a basket of securities, stock indices or securities listed in other jurisdictions will always be settled by cash.   

When a physically settled call derivative warrant on a single stock is exercised, the warrant holder will receive the underlying stock from the issuer.  Unlike equity warrants, no new shares will be issued. 

The issue and exercise of derivative warrants has no effect on the quantity of the underlying assets (such as ordinary shares).  Derivative warrants provide the market with a wider range for instruments for hedging or investment purposes.

 

6.5.2

How do derivative warrants work?

Derivative warrants are generally divided into two types: calls and puts.  Holders of call warrants have the right but no obligation to purchase from the warrant issuer a given amount of the underlying assets at a predetermined price (also known as the exercise price) within a certain time period.  Conversely, holders of put warrants have the right but no obligation to sell to the warrant issuer a given amount of the underlying assets at a predetermined price within a certain time period.  Derivative warrants are "exercised" when holders use their rights to purchase or sell the underlying assets.  Under the existing Listing Rules, derivative warrants have a maximum life of five years, but most derivative warrants in the market tend to have shorter lives – normally six months to two years.

Those who buy call warrants usually hold a bullish view of the price of the underlying asset.  The holder of a call warrant may sell the warrant or wait until the expiry date.  At the expiry of a call warrant, if the price of the underlying assets is higher than the derivative warrant's exercise price, the derivative warrant is "in-the-money" and will be exercised automatically.  The holder of a cash-settled derivative warrant (almost all derivative warrants currently listed in Hong Kong are cash-settled) will receive a cash payment of an amount equal to the positive difference between the settlement price and the exercise price of the call warrant adjusted by the entitlement ratio.  The settlement price of a call warrant is the 5-day average closing price of the underlying assets prior to the expiry date.  On the expiry date, if the settlement price of the call warrant is lower than its exercise price, the derivative warrant is “out-of-the-money and will become worthless.

Buyers of put warrants usually hold a bearish view of the price of the underlying assets.  The holder of a put warrant can sell it or wait until expiry.  At the expiry of a put warrant, if the price of the underlying assets is lower than the derivative warrant’s exercise price, the derivative warrant is “in-the-money” and will be exercised automatically.  The holder of a cash-settled warrant (almost all derivative warrants currently listed in Hong Kong are cash-settled) will receive a cash payment of an amount equal to the positive difference between the exercise price of the put warrant and the settlement price of the underlying assets adjusted by the entitlement ratio.  The settlement price of a put warrant is the 5-day average closing price of the underlying asset prior to the expiry of the warrant.  On the expiry date, if the settlement price of the underlying assets is higher than the exercise price, the derivative warrant is “out-of-the-money” and will become worthless.

Investors should note that if trading in the underlying assets of a derivative warrant is suspended, trading in the warrant will also be suspended until trading in the underlying assets resumes.  In addition, to ensure that a trade executed on the last trading day has sufficient time for settlement and any registration, there shall be three settlement days between the last trading day and the expiry day.  In general, trading days are also settlement days, except that Christmas Eve, New Year’s Eve and Lunar New Year’s Eve will normally be prescribed by the Exchange as non-settlement days.

 

6.5.3

How are derivative warrant holders different from shareholders?

Holders of derivative warrants on single stocks do not have the same rights as shareholders of the underlying stocks. Derivative warrant holders do not have voting rights or the right to receive any dividends or bonus distributions from the issuers of the underlying stocks.  The life of a derivative warrant is finite and its holder must sell or exercise the derivative warrant before it expires and becomes worthless, whereas shareholders can hold shares for long term investment.

 

6.5.4

What are the factors determining the price of a derivative warrant?  Why is the price movement of a derivative warrant not directly proportional to that of its underlying assets?

The price of a derivative warrant at expiry mainly rests with the price of the underlying assets.  However, so long as a derivative warrant remains valid, its price will be affected by other factors in addition to the underlying assets’ price. They include the volatility of the underlying assets’ price, the exercise price, the time remaining to expiry, interest rates and expected dividend payments on the underlying assets, etc.  Like other securities, the price of a derivative warrant may also be affected the supply of and demand for the derivative warrant itself.  Various mathematical formulae are used by market players to calculate the theoretical prices of derivative warrants and those theoretical prices often differ from market prices.

 

6.5.5

What are the risks to be considered by investors before trading in derivative warrants?

Investors should understand and consider the risks below before trading in derivative warrants and contact their dealers or financial advisers for details.

  1. Issuer risk: Derivative warrant holders are unsecured creditors of the issuer and they have no preferential claim to any assets an issuer may hold.
  2. Gearing risk: Although derivative warrants often cost less than the price of the underlying assets, a derivative warrant may change in value to a much greater extent than the underlying assets.  Although potential return on derivative warrants may be higher than that on the underlying assets, it should be noted that in the worst case the value of derivative warrants may fall to zero and holders may lose their entire investment amount.
  3. Limited life: Unlike stocks, derivative warrants have an expiry date and therefore a limited life.  Unless the derivative warrants are in-the-money, they become worthless at expiration.
  4. Time decay: So long as other factors remain unchanged, the value of derivative warrants will decrease over time. Therefore, derivative warrants should never be viewed as products that are bought and held as long term investments.
  5. Market forces: In addition to the basic factors that determine the theoretical price of a derivative warrant, derivative warrant prices are also affected by the demand for and supply of the derivative warrants.  This is particularly the case when a derivative warrant issue is almost sold out and when there are further issues of an existing derivative warrant.
  6. Turnover: High turnover should not be regarded as an indication that a derivative warrant’s price will go up.  The price of a derivative warrant is affected by a number of factors in addition to market forces, such as the price of the underlying assets and its volatility, the time remaining to expiry, interest rates and the expected dividend on the underlying assets.

 

6.5.6

What are exotic derivative warrants?  What are the differences between an exotic derivative warrant and a standard derivative warrant?  

There are various types of derivative warrants in the market.  Exotic derivative warrants carry exotic features and their terms may be more complicated than other derivative warrants.  An exotic derivative warrant is identified with an "X" in its English short name.  For more details, investors should refer to the listing documents and consult their dealers.

 

6.5.7

How is the settlement price of a derivative warrant calculated?

For derivative warrants issued on a single stock traded on the Stock Exchange, the settlement price is calculated based on the 5-day average closing price of the underlying stock prior to and excluding the expiry day.

For index warrants, the settlement price is usually based on the final settlement price of the corresponding index futures contract of the same expiry month traded on the Futures Exchange.

 

6.5.8

What are the differences between a zero/low strike DW and other products?

 

Zero/low strike DW

Higher strike DW

CBBC

Exchange Trade Fund, or ETF

Issuer

Eligible Issuers

Eligible Issuers

Eligible Issuers

Fund Managers

 

Trading platform

The Exchange’s trading system

The Exchange’s trading system

The Exchange’s trading system

The Exchange’s trading system

 

Response to underlying assets’ movement

Tends to closely track the relative performance of the underlying assets

Depends on various factors such as interest rates, delta and volatility

 

Tends to closely track the absolute performance of the underlying assets

Tends to closely track the relative performance of the underlying assets

Holding cost

No time decay

With time decay

No time decay

No time decay

 

Implied volatility

Insignificant to pricing

 

Affects pricing

Insignificant to pricing

Insignificant to pricing

Funding costs or management fees charged by issuers

The formula for calculating management fees is stated in the listing document

The funding costs are built into the premium of the DW

The formula for calculating funding costs is stated in the listing document

The management fee is stated in the prospectus (eg, 1% of the fund’s net asset on quarter’s last dealing day)

 

Capital adjustment

As stated in the listing document

As stated in the listing document

If underlying assets are shares of a Hong Kong-listed company – follow stock futures arrangements 

 

Reflected in the value of the portfolio

Mandatory call/knock out

No

No (but possible for exotic DW)

 

Yes

No

Duration allowed

6 months to perpetual (with a possibility of rollover every 5 years)

 

6 months to 5 years (without rollover)

3 months to 5 years (without rollover)

Perpetual

Underlying assets

Wide range of underlying assets not listed in Hong Kong

Wide range of Hong Kong-listed and other underlying assets

 

Wide range of Hong Kong-listed and other underlying assets

Wide range of Hong Kong-listed and other underlying assets

 

6.5.9

What are the major risks in trading derivative warrants on underlying assets not listed in Hong Kong?

Like other products listed on the Stock Exchange, derivative warrants on underlying assets not listed in Hong Kong are traded on the Hong Kong securities market during the Stock Exchange’s regular trading hours rather than the trading hours of their underlying assets in overseas markets. The major risks in trading these products included:

Price volatility

The trading price of a zero/low strike MAP tends to mirror the movement of the value of the underlying assets and any corresponding foreign currency, both of which can be very volatile.  In addition, MAP may be subject to possible adjustments for dividend payments (if any) and management fees charged by the issuer if applicable.

Degree of tracking error

Although the trading price of a zero/low strike MAP tends to track the movement of the value of the underlying assets and any corresponding foreign currency, there may be a certain degree of tracking error depending on how the prices of individual MAP are adjusted for the payment of management fees, treatment of dividends by the underlying equity indices (if any) and the bid-ask spreads when MAP are traded on the Exchange.  Investors should refer to the listing documents of MAP or consult the issuers or their investment advisers for details.

Exchange rate risk

Unlike MAP which are traded and settled in Hong Kong dollars, the trading prices of the underlying assets of MAP, which are not hedged against foreign exchange risk, will normally be quoted in a foreign currency and thus there is exchange rate risk involved.

Exposure to issuers

Similar to other structured products, MAP are not collateralised and are subject to the creditworthiness of the issuers.

 

6.5.10

What information is included in the short name of a derivative warrant? 

Investors can learn some basic features of a derivative warrant from its stock short name. Below are the naming conventions for reference. 

Z

Z

Q

Q

Q

Q

Q

@

E

C

Y

Y

M

M

A

 Or

Z

Z

-

Q

Q

Q

Q

@

E

C

Y

Y

M

M

A

 Or (traded in Renminbi)

Z

Z

Q

Q

Q

Q

@

E

C

Y

Y

M

M

A

*

  ZZ

Issuer's short name

Q

Up to 5 characters representing name of the underlying asset

@

@ = Cash settlement ; * = Physical delivery

E

E = European ; R = Regional warrants ; X = Exotic (non-traditional) ; No Character = American

C

C = Call ; P = Put ;  No Character = non Call or Put

YYMM

Expiry year and month

A

Serial number for additional issues by the same issuer on same underlying asset with same expiry year and month (A, B, C ...)

*

Indicator for DWs traded in Renminbi (RMB)

The above naming convention for DWs comes into effect on 27 Feb 2012.  The stock short name of DWs launched before 27 Feb 2012 will remain unchanged.  There is no serial number assigned to the first issue of DWs launched before 27 Feb 2012 (i.e. ZZ-QQQQQ@ECYYMM).

Investors should note that the above naming conventions are applicable in most cases but not exclusive for all circumstances.  The short names of derivative warrants indicate some basic information only.  Investors should refer to the listing documents of issuers and consult their brokers or investment advisers before trading. Listing documents can be found at “Securities Products” under the "Products & Services" section of the HKEX website.

 

6.5.11

What is the difference between historical volatility and implied volatility?

Volatility of derivative warrants is determined by annualised statistics measuring the price changes of the underlying assets: the greater the fluctuations, the higher the volatility.  Historical volatility is a measure of price fluctuations over a period in the past.  Implied volatility is the anticipated level of volatility of the underlying assets over the remaining life of a derivative warrant as reflected by the price of the derivative warrant, and is derived using a theoretical pricing model.

 

Trading Arrangement

6.5.12

How can investors obtain information about derivative warrants listed on the Exchange? 

The price of derivative warrants is available from many information vendors through their terminals or websites.  Other information such as listed issuers' announcements and listing documents are available in the "Derivative Warrants" of "Securities Products" under the "Products & Services" section of the HKEX website.

 

6.5.13

How are derivative warrants traded on the Exchange?    

Derivative warrants are traded on the Exchange during trading hours in board lot multiples settled on T+2 (T being the transaction day). Investors may contact their brokers for placing orders.

 

6.5.14

What transaction fees are payable on buying or selling derivative warrants?      

Similar to the stock trading arrangements, transaction fees include brokerage commission, transaction levy, trading fee and investor compensation levy (suspended since December 2005). In general, derivative warrants are cash settled and are not subject to stamp duty.

 

6.5.15

When and how is a cash-settled derivative warrant exercised?

Cash-settled derivative warrants that are in-the-money on the expiry day are usually exercised automatically.  Warrant holders are then paid a positive cash settlement amount according to the terms and conditions in the listing documents.

 

6.5.16

What happens when a derivative warrant settled by physical delivery is exercised?

Issuers settle either by physical delivery of documents of title (including certificates in the name of the warrant holder or the holder’s nominee) or by electronic transfer through HKEX’s Central Clearing and Settlement System (CCASS) to the warrant holder (or the holder’s nominee) within a specified period following a valid exercise. In practice, however, almost all derivative warrants currently listed in Hong Kong are cash-settled.

 

6.5.17

Can derivative warrants be sold on the expiry day?

No.  The expiry day of a derivative warrant is not the same as the last trading day.  To ensure that a trade executed on the last trading day has sufficient time for settlement and any registration, there are three settlement days between the last trading day and the expiry day.  Investors can only trade the derivative warrant on or before the last trading day.  For example, if a derivative warrant expires on Friday, 23 June, the last day of trading will be Monday, 19 June (assuming all days from 19 to 23 June are settlement days).  In general, a trading day will also be a settlement day, except that Christmas Eve, New Year’s Eve and Lunar New Year’s Eve will normally be prescribed by the Exchange as non-settlement days.

 

Liquidity Provision

6.5.18

What are the obligations of a liquidity provider for a derivative warrant?

The listing document lists the exact obligations of the liquidity provider.

Derivative warrant issuers are required to appoint a liquidity provider for each of their listed derivative warrants.  In Hong Kong liquidity providers for derivative warrants are commonly known as “market makers”. Each liquidity provider is identified by a 95XX, 96XX or 97XX code.  The listing document of an issuer sets out the exact obligations of the liquidity provider.

In normal circumstances, liquidity providers should provide liquidity for derivative warrant issues through continuous quotes or in response to quote requests from five minutes after the market opens until the market closes.  The liquidity provider should provide liquidity for at least a certain number of board lots of the derivative warrant.  An issuer must specify the maximum spread between the bid and offer prices for its derivative warrants in the listing document.  Under the quote request system, investors may request a quote from the liquidity provider.

 

6.5.19

How can investors contact liquidity providers to request quotes?

An investor can contact his broker to request a quote from a liquidity provider if the listing document says quotes are provided upon request.  For derivative warrants with liquidity providers that respond to quote requests, the telephone numbers of the liquidity providers are available on the derivative warrants' stock pages, in the listing document and on the HKEX website.

 

6.5.20

Why are there sometimes no quotations for some derivative warrants?

Some derivative warrants may not be traded actively compared with others and hence there are no orders from investors. When derivative warrant issuers have the Liquidity Provider provide liquidity in response to quote requests, investors can request quotes from the Liquidity Provider. Also, when the issuer has sold the entire approved supply of the derivative warrants, the issuer is no longer required to quote ask prices for that issue. There are also some special circumstances in which Liquidity Provider are not required to provide quotes. These circumstances are stated in the listing documents of the derivative warrants.

 

6.5.21

How can an investor find the name of the Liquidity Provider appointed by an issuer?

Investors can obtain the information either by visiting the HKEX website or by referring to the listing document. The HKEX website provides useful information such as announcements, listing documents and Liquidity Provider information. Investors may refer to "Derivative Warrants" of "Securities Products" under the "Products & Services" section of the HKEX website.

 

6.5.22

How many Liquidity Providers can an issuer appoint for each derivative warrant issue?

For each derivative warrant issue there can only be one Liquidity Provider.

 

6.5.23

How can an investor request prices from a Liquidity Provider?

Under the quote request system, an investor can request a quote from the Liquidity Provider. The telephone numbers of the Liquidity Providers are available on AMS/3's derivative warrant pages, in the listing documents or in HKEX website.

 

6.5.24

Under what circumstances is the Liquidity Provider not required to provide liquidity?

The circumstances in which the Liquidity Provider is not required to provide liquidity are described in the listing document.  Investors should refer to the listing document for details.

 

6.5.25

If the appointed Liquidity Provider is no longer a Stock Exchange Participant, can that Liquidity Provider continue to provide liquidity?

If the appointed Liquidity Provider is no longer a Stock Exchange Participant, HKEX has the right to prohibit the Liquidity Provider from continuing in that role.

 

6.5.26

Is an issuer required to appoint another Liquidity Provider if the existing Liquidity Provider is disqualified?

If the derivative warrant has not expired, the issuer must appoint another Liquidity Provider if the existing Liquidity Provider is disqualified.

For further details, please refer to "Derivative Warrants" of "Securities Products" under the "Products & Services" section of the HKEX website.