Dear Readers,

Recently, one of our members queried us on HDFC warrants. The same was discussed as an investment option with a probable return on 60% on one of the leading business channels….(refer the link below)

http://www.moneycontrol.com/news/market-outlook/sp-tulsian39s-top-picks-hdfc-warrants-grindwell-norton_606522.html#toptag

Through this post we would like to make sure that all reading this should clearly understand the risks involved as we believe the commentator in the above link missed some very important points.

Some background into the HDFC (Housing Development Finance Corporation) warrants.

In Aug’09 HDFC issued 1.095 crore warrants, priced at Rs 275 each, entitling the holder to convert each of them into a single equity share of the corporation within three years from the date of allotment at an exercise price of Rs 3,000 a share. Since then the stock’s been split from a Face Value of Rs 10/- to a Face Value of Rs 2/-.

So as per the current status there are 5.47 crore outstanding warrants issued at a price of Rs 55/- each entitling shareholder to convert each warrant into equity share at an exercice price of Rs 600/- per share by Aug’12.

The warrants are currently trading at Rs 115/- per warrant. So going by the recommendation in the above link, if one decides to buy the warrants at current price in anticipation of selling them at a 40-50% profit (please refer the recommendation in the above link) around Jul-Aug’12, one has to understand that the only case where an investor would be profitable is if the stock i.e. HDFC (currently quoting at Rs 687/- per share) goes above Rs 725/- per share by Aug’12.

In case the stock continues to languish around current levels, the investors holding warrants will lose 20-30% on their investment while the investors holding HDFC equity shares would still gain Rs 10/- per share as dividend.

Let’s understand in a better manner

The HDFC warrants are just like a call option. While in India the options are usually available with a maximum expiry of 2 months (very illiquid), here the call option is valid till Aug 2012. So, the same is good only if one believes that HDFC will quote in excess of Rs 725/- (Rs 115/- per warrant + Rs 600/- per share + Rs 10/- per share dividend by Jun’13. Warrant holders are not entitled for dividend) per share by Aug’12. Also, its worth taking a risk only if someone is very sure that stock will go up to 750-760/- per share because only then does one make 30% return in 10 months else why should one risk his/her capital when the evident risks are pretty high.

Even if HDFC doesn’t move and still quotes at 680 by Aug’12, one would bear a loss as the value of warrants will go down to Rs 80/- (no time premium near expiry).

It’s a case of pure speculation just as anyone does by buying short term options. Predicting stock price movements over such a short period of 9-10 months is very speculative. Though HDFC is a very good company, but predicting short term price movements is always fraught with risks, no matter how good a company be.and in case of short term options (especially when you buy options) you always find yourself running against time.

Also there would be an equity dilution to the tune of 3.5% on conversion of warrants into equity shares.

Hope the above helps you in making a smarter decision.

Ekansh Mittal [ekansh@katalystwealth.com]