The following is the formula for a properly structured warrant tied to Japan’s Nikkei index — which would (we presume) be easy enough to hedge for its issuer:
(Closing Level – Strike Level) x Index Currency Amount / Exchange Rate.
What follows is the formula attached to four recent warrants tied to Japan’s Nikkei index issued by Goldman Sachs:
(Closing Level – Strike Level) x Index Currency Amount x Exchange Rate.
Spot the difference?
In one, the index currency amount is divided by the exchange rate, in the other it is multiplied by the exchange rate.
It may be a small error, but according to the Economist (hat tip to our FT Tilt colleague Stacy-Marie Ishmael for flagging the story up), the typo is fast becoming a costly headache for Goldman Sachs in Asia.
As the magazine noted last week, having spotted the error, Goldman Sachs offered a 10 per cent premium to buy the contracts back from the market. Investors, however, have not budged easily. Most are insisting that the bank honours its typo-ridden terms.
That, needless to say, would be a blow for Goldman.
The Economist estimates the typo could expose the bank to as much as HK$350m instead of the HK$10m initially offered on the warrants, which are basically a type of derivative with a limit on losses, similar to options.
On the investors’ side is also the fact that Goldman may not have conducted itself in a forthright manner upon discovering the mistake.
As the Economist noted:
Holders also allege that after it notified the exchange of the problem but before trading was frozen, Goldman continued to bid to buy back the warrants while ceasing sell offers that would have meant disclosing the real price based on the prospectus. Goldman merely says it made offers at the “correct” price.
Understandably, while the two sides wrangle over the conclusion to the saga, the notes themselves have been suspended by the exchange.
Whatever it is, though, may have important implications for the wider market.
First, the Hong Kong exchange-traded warrant market is vastly popular — much more so than it is in the United Kingdom and the United States, where the products never really took off because they were seen as more expensive than rival products. According to the Economist, some 14,400 warrants were issued in Hong Kong last year alone. Each series would have carried its own phonebook-sized prospectus.
Not only does the Goldman case make you wonder about the attention to detail paid to the former prospectuses that are out there, it raises questions about what classifies reneging in the first place.
As the Economist notes:
“If it was possible to renege even on what was written down in black and white, how can we possibly be an international financial centre any more?” asked James To, a member of the Legislative Council (Legco), at a hearing in April; another Legco hearing was held this week and a further one is due in June. Perhaps the biggest question of all concerns the complexity of these instruments. What other risks might be lurking in the market undergrowth?
Furthermore, in the event that Goldman does get to backtrack on the prospectus, there’s the question if the same would apply to anyone else making a similar mistake.
Many in the market are not so sure.
One last thing. The saga may also finally shed some light on warrant pricing practices, and specifically to what degree they are potentially mis-priced versus rival products in the market.
Trader admits manipulating price of warrants – Straits Times
Banks devise new structures that bet on the markets – FT
All eyes on broker-dealer internalisation – FT Alphaville