Budi Frensidy: Structured Warrants: The Exchange’s New Product


Structured Warrants: The Exchange’s New Product

By: Prof. Dr. Budi Frensidy – Professor of Finance and Capital Markets UI

KONTAN – (22/8/2022) One of the capital market products traded on many exchanges is stock options. On the domestic stock exchange, stock options were traded in 2004-2005 and then died in 2006. Trading was revived in 2007 but went back to sleep a year later. Now stock options will be offered again under the name of structured warrants. What are the options?

An option is a contract that gives the holder the right to buy (call) or sell (put) an underlying asset at a specified price before or on the agreed date.

Suppose you hold a call on PT Bukit Asam Tbk (PTBA) shares, for example. In that case, you have the right to buy the shares at a predetermined price (exercise price), say Rp4,000, in three months (European type) or during the current three months (American type) or any other period.

The option will be in the money if PTBA’s share price exceeds Rp4,000. However, the option will be out of the money if PTBA’s share price is below Rp4,000 per share.

For warrants structured on the Indonesia Stock Exchange (IDX), those who will issue or sell in the primary market, or hold a short position, are members of the exchange. The underlying assets used are IDX30 stocks, with a period of two months to two years, and can only be exercised at maturity (European style) with cash settlement, not with the delivery of underlying assets.

An option is a contract between two parties, one who buys (long) and one who sells (short). Ignoring the position in the underlying asset, under any circumstances, the profit made by the buyer is a loss to the seller. Vice versa, a loss for the buyer is a gain for the seller or a zero-sum game, as it is called.

If the option holder is happy, then the option seller will be difficult, and vice versa, aka SMS, which is happy to see the opponent challenging and difficult to see the opponent happy because that is the characteristic of a zero-sum game.

The payoffs of long and short positions are different. The potential profit of a long position, which is the loss of a short position for a call option, is relatively unlimited. At the same time, the potential gain of a short position and the potential loss of a long position for a put option is always limited to the price of the option it receives. The story will differ if the person transacting the option above owns the underlying asset.

If the seller of the PTBA call above owns this stock, when the PTBA price rises, then he will not be too sad. He will hand over the PTBA shares in his portfolio to the holder of the option he sold.

Thus, the short call here is protected and called a covered call. His potential profit from the increase of PTBA shares he owns is limited, but the possibility of unlimited loss from selling the call is also lost.

In addition to speculation, options can be used for hedging purposes such as insurance. If you own shares of PT Astra International Tbk (ASII) and are worried that the price will drop below Rp7,000 in the next few months, you can simply buy a put option with an exercise price of Rp7,000.

If ASII’s share price does drop to Rp6,000, you can simply exercise this right to sell it at Rp7,000. That is called a protective put.

Option valuation with its two main models, Black-Scholes (continuous variable) and binomial (discrete variable) is more complex than stocks, although there are far more stock valuation methods.

That is because we need five variables, especially for the Black-Scholes model, which won the 1997 Nobel Prize in Economics, namely the underlying asset price (S), exercise price (X), period to maturity (t), interest rate (r), and volatility of the underlying asset. Unfortunately, not all of these variables are available in the market, as it is impossible to obtain the future volatility of the underlying asset.

Put-call parity

This is just for calls. What about puts? For practical purposes, most books do not explicitly write the equation for the put value anymore. However, the put value can be easily found once the call price is obtained, using an equation known as the put-call parity.

The logic of this parity is that, if desired, the promised payoff of owning a put is the same as the payoff of a call. Each of these options must, of course be combined with other assets.

To illustrate, an investor who owns PT Telkom Indonesia (Tbk) TLKM and puts this stock at an exercise price of Rp4,500 will be assured that his portfolio will never be worth less than Rp4,500. However, the investor will exercise his option to sell TLKM shares if the market price of TLKM is lower than Rp4,500 per share.

This exact payoff can also be done by having a call and some money to execute the call at Rp4,500. The amount of money needed is not Rp4,500 but below this number, which is the present value (PV) if using a continuous equation.

With this amount of money and a call, the investor’s portfolio is worth at least Rp4,500 in cash, which is when the price of TLKM is below Rp4,500, and the option is not exercised. Conversely, if the price of TLKM shares is above Rp4,500, the investor will exercise his option, so his portfolio will be worth the price of TLKM.

Thus, owning TLKM stock and its put will always equal the payoff of holding the call and the cash to exercise it.

Source: Kontan Newspaper. Edition: Monday, August 22, 2022. Portfolio Rubric – Wake Up Call. Page 4.