UK Covered Warrants

Covered Warrants were introduced on the London Stock Exchange one year ago with a great bang of publicity. Since then the market seems to have gone very quiet, in fact we'd forgotten all about them. But last week we received an email from a subscriber asking some questions so we decided to have a look into the Covered Warrant market again.

From the start it was obvious to anyone with experience of financial products that Covered Warrants were yet another subtle way of transferring wealth from clients' pockets into those of the banks that offered them. Searching around the web we found this very interesting piece from the November 2003 issue of Futures & Options World, and it sums up perfectly the state and ultimate goals of the Warrant market promoters.

"Covered warrants are not going to be big in the UK, whatever the time frame. This may be a broad statement to make and just because they have had considerable success in certain European countries, there is absolutely no reason to believe that a similar pattern will be repeated in the UK.

I first came across covered warrants in the late 1980s when I was a foreign exchange trader. The German subsidiary of the bank I was working for listed some currency warrants and covered them with an over-the-counter option. The amount of money it made was staggering, especially as it had virtually no risk left on its own book. Being a typically cynical trader, the only conclusion I could arrive at was that someone must have been well and truly ripped off.

A decade and a half later, I am convinced that this judgement was correct. In the intervening years, nothing has fundamentally changed. If I am charitable, I would describe covered warrants as a poor value product. If I were more open, I would describe them as a complete and utter rip off - a product that retail investors should be educated to avoid. There is little need to educate wholesale or professional players, because they know this already.

This is one of the great mysteries about the launch of covered warrants in the UK. Ask any professional option market participant for their view on covered warrants, and you will undoubtedly be told that they are indeed extremely expensive. However, because they could be a lucrative product for the banks writing them should they prove popular, a code of omerta exists. This means that very few professional traders and brokers will state the simple fact that warrants are generally far more expensive than comparable options.

A feature of the covered warrants market is that investors are not allowed to sell them. So there is a tendency for them to be priced extremely expensively at launch, when the retail market will supposedly buy them. They then tend to get cheaper, at least versus similar options, as they near expiry, when any mug punters, or retail investors, still long will be looking to sell.

There are numerous examples of how expensive they are. One is the 150p covered warrant call on UK mobile telecom Vodafone expiring June 2004 issued by Goldman Sachs. This is bid 6.35p. The listed 150p June call option listed at Euronext/LIFFE is offered at 4p, a discount of 37% to the warrant's bid.

The poor value extends to other asset classes. For instance, a 1.60 sterling call versus the dollar (cable) covered warrant offered by SG and expiring June 7, 2004, is bid at 26p. The offer price for an option with exactly the same details is 19p in the interbank market.

Julian Quinn, head of options at spread better City Index says: “The whole thing about covered warrants is that they've been designed to allow institutions to sell expensive volatility.” Quinn claims that some of the warrants based on FTSE-100 options are currently being priced off implied volatilities around 35%, while the true level in the market is 18.5%.

In recognition that covered warrants can potentially be viewed as a rip off, one private client broker in London says that anybody who actually sells one to a customer must point out that similar products are often available at a far cheaper price. If they do not do this, then they run the risk of misselling.

Bruce Williams, an investment director at BWD-Rensburg, voices a similar opinion. “What's so stupid is that there are similar products available with exactly the same risk profile and which are far cheaper,” he says.