The total outstanding quantity of call warrants of Bank of China Ltd increased 7 percent from HK$4.9 billion to HK$5.25 billion last week after the company claimed it had set aside enough money to cover investments in securities tied to US subprime mortgages.

The news stimulated the stock to surge 7.8 percent last Tuesday, and many of its call warrants jumped over 40 percent. But does that mean the warrant issuers lose to investors in the case?

In fact, that's not the case. There is a common misconception among the investing public that warrant investment is a zero-sum game - one party must lose in order for the other party to gain. Issuers are therefore betting against the warrant investors, making them competitors.

This notion can't be further from the truth. Why? Because issuers hedge their positions when they sell warrants. Using a call warrant as an example, when Societe Generale (SG) sells warrants in the market, the premium collected will be used to buy an over-the-counter (OTC) option, underlying itself or using other financial products to hedge against the warrants sold.

Any gains made by the warrant holders if the warrant price rises are not losses incurred by SG. Profits made by warrant holders will be offset by the gains made from the hedging instrument, whose price will also rise. SG will sell the hedging instrument and use the profit to pay the warrant holders. Should the warrant price fall due to change in the underlying price, the hedging- instrument price will also fall. Again, SG will not profit from the fall in the warrant price.

The issuer and the investor are, therefore, not betting against each other - one party does not have to lose for the other party to gain. Investors, when they buy warrants, are looking for gains arising from getting the direction of the underlying right. Issuers, on the other hand, take a neutral stance and earn a spread from selling the warrant - the volatility spread between an OTC option and warrant.

Finally, warrant investment does not have to be a "zero-sum game" but can be a "win-win situation" for both the issuers and investors.

SG Securities (HK) Limited provided the article.

(HK Edition 02/25/2008 page1)