Leveraged exposure refers to the ability of a warrant holder to gain amplified exposure to the price movements of an underlying asset, such as a stock or index, without have to pay the full value of that asset upfront.

Investment warrants offer leveraged exposure to shares, Exchange Traded Funds (ETFs) and other underlying assets. Some investment warrants, such as Instalment warrants, can provide access to any dividends and franking credits. 

Instalments are a key type of warrant on ASX. They provide exposure to an underlying share by making an initial payment (the first instalment) and deferring an optional final payment (the final instalment) to a later date, if they choose to exercise. In simple terms, instalments are a loan to buy shares or ETFs, without the obligation to repay the loan or the risk of receiving margin calls. 

During the life of an instalment, investors benefit from any dividends, franking credits and potential price rises, in the same way if they owned the share over which the instalment is based. When the instalment warrant matures, the investor can choose to pay a final instalment and take ownership of the share, roll over into a new warrant series, or end the investment and receive any residual value.

The main risk is adverse market movements. The value of an instalment depends on the value of its underlying asset. If the price of that asset falls, the value of the instalment falls. Leverage magnifies gains and losses, meaning a small adverse movement in the underlying asset can potentially lead to significant losses in the instalment. In some cases, investors could lose all or part of their initial investment (the first instalment). Conversely, investors can potentially magnify gains through a small increase in the price of the underlying asset, if their view is correct.

Consider a hypothetical example of an investor who wants exposure to Company XYZ shares that trade at $10 a share, through an instalment warrant.

Example

The first instalment is $6 (it includes interest costs) and the second (final) instalment is $5. The expiry date is in 12 months. 

If XYZ shares fall from $10 to $8 by the expiry date, the investor has to pay $5 in the second instalment if they choose to exercise. The total cost is $11 ($6 first instalment plus $5 second instalment). With XYZ shares now worth $8, the investor has lost $3 ($11 less $8). 

(Note: If the investor fails to exercise the Instalment by closing time on the maturity date, the underlying shares may be sold by the Issuer. The proceeds will be used to repay the loan and any other exercise costs. The remaining funds may then be paid to the investor.)

Conversely, if XYZ shares rise from $10 to $15 at expiry, the investor has made $4 ($15 less $11) after paying the $5 second instalment. In this example, their $11 total investment (the two instalments) is now worth $15.

The investor may have also benefited from any dividends and franking credits on XYZ shares during their ownership of the instalment, and interest costs on the instalment may be tax deductible, assuming specific conditions and rules are met (investors should seek independent tax and financial advice on the tax-deductibility of the instalment for their personal circumstance).

Researching warrants

This brief explanation of the features, benefits and risks of warrants highlights a few things. First, that warrants are typically used by more experienced investors and traders who have a higher risk tolerance. That is, investors who understand the pros and cons of using leverage (borrowing) to gain exposure to an asset. 

Second, that investors should do their own research and speak to an accredited financial adviser before investing in them. Not every investor can use warrants. There are suitability requirements and investors must sign a Warrant Client Agreement with their broker before they are able to invest in warrants.

Investing in Warrants on the ASX website has information on the features, benefits and risks of warrants, and is a good place to start for basic information on warrants. 

Potential warrant risks include magnified losses through the use of leverage, liquidity risk, the limited life of most warrants, early termination of warrants in some cases, and issuer risk. Like other derivative products, warrants can be complex and require more day-to-day monitoring.

Tian expects strategies such as using instalment warrants to potentially maximise yield, or to gain leveraged exposure to Exchange Traded Funds to be in focus this financial year. Using MINI shorts to hedge a portfolio, in anticipation of a falling share price or sharemarket index, could also feature more prominently. Tian says ‘shorting’ a stock, in Citi’s view, can be a high-risk strategy.

Possible uses 

Here are five possible uses for warrants this financial year and beyond. Investment Strategies for Warrants has more information on each possible use.

1. Simple leverage: An investor seeks leveraged exposure to a stock or index to gain exposure to potential gains and dividends without margin calls. A MINI long warrant might be considered for this purpose, but like all warrants, MINI longs can magnify losses. 

2. Self-Managed Superannuation Funds (SMSFs). Here, an investor seeks exposure to potential capital growth for their SMSF, as well as any dividends or franking credits. They might consider an instalment warrant for their SMSF, which provides leverage and is a limited recourse loan.

3. Dividend yield. An investor uses a warrant to potentially enhance any dividend yield and franking credits, using less capital than is normally required from investing in shares. They might consider an instalment warrant for this strategy. Although dividend yield may be enhanced, there is still the potential for a negative total return (capital growth and dividends) if the price of the underlying asset falls.

4. Falling market. An investor who expects the Australian sharemarket to fall might seek to profit from that view using trading warrants. They may also want to adopt this strategy to protect an existing share portfolio (i.e. to hedge their exposure to market movements). They might consider using a MINI short to potentially profit from a falling share price or index - a higher-risk strategy that will result in losses on the MINI if their view is incorrect.

5. Cash extraction: An investor wants to make a new investment without investing more capital or realising their existing holdings. Their goal could be to minimise their tax liability or improve their portfolio diversification. They might consider lodging shares they already own with a warrant issuer and receiving an equivalent number of instalments plus a cash payment that can be used for new investments. The main risk with this strategy is market risk, where the value of the underlying assets falls, meaning the value of the instalment falls. 

Conclusion

This article briefly outlined how warrants work, the main types of warrants, their key risks and potential ways to use them. Warrants have many uses and can potentially achieve portfolio goals not possible through investing in shares or ETFs on their own. But warrants come with higher risk, are more complex, and require more monitoring and research.