Capital Plus Warrants

Abstract

A capital plus warrant (CPW) is a third-party-issued derivative contract (on an underlying portfolio of equities) traded on the Australian Stock Exchange. The investor in a capital plus warrant is guaranteed the initial investment amount plus a return based on the performance of the underlying equity portfolio, but does not receive the dividends on the underlying shares. This article first examines the pricing of this security, which can be modeled as a combination of a risk-free bond and a call option on the equity portfolio. A simple model for valuing capital plus warrants is derived. Second, the article examines the determinants of the terms of the CPW and methods by which the issuing institution might hedge the risk created by the sale of the security. The CPW offers a risk-return profile that the retail investor is not able to obtain using other securities. The issuer is able to reduce the cost of funds from around 7.5% to 6.4%.