Warrants: the classic leveraged product
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Warrants are the most popular and top-selling leveraged product by some distance. Their simple form and the lack of specific construction mechanisms are their two biggest assets.
A warrant is the securitised form of a plain vanilla option. It allows investors to participate disproportionately (using leverage) in the performance of an underlying with a comparatively low capital outlay. Investors can capitalise on either rising or falling underlying prices depending on whether they choose a call or put warrant. In addition to their speculative character, warrants can be used to help hedge an existing portfolio or individual positions against an undesirable price trend. A great advantage of this type of product is its simple and understandable functionality. The value of a call warrant increases when the price of the underlying rises and decreases when it falls. Conversely, the value of a put warrant decreases when the price of the underlying rises and increases when it falls. Call and put warrants are included in various structured products in their basic form. In contrast to all other product types, they are not made up of several components. This means that there is no specific construction mechanism.
Examples of the development of call and put warrants
Two fictional examples are set out below to demonstrate the development of call and put warrants when the price of the underlying rises and falls.
Term: 1 year
Underlying: Example Ltd
Reference price: CHF 100
Strike (call and put warrant): CHF 110
Ratio: 10
Call price: CHF 0.50
Put price: CHF 1.20
Scenario 1: the price of underlying rises
In this scenario, the share price of Example Ltd rises and reaches CHF 135 after a year. At the end of the call warrant’s term, the difference between the value of the stock and the exercise price (strike), divided by the ratio, is paid out. The absolute profit is the difference between the payout at the end of the term ((CHF 135 — CHF 110) / 10 = CHF 2.50) and the call price of CHF 0.50 paid at the start, i.e. CHF 2.00. This represents a return of 400%. The Example Ltd share price «only» increased by 35% over the same period. The warrant’s disproportionate increase in profit is known as leverage. It results from the fact that investors have to deploy significantly less capital than they would by investing directly in the underlying. The following chart shows the payoff diagram for the aforementioned call warrant.
Chart 1: Payoff diagram of a call warrant
Scenario 2: the price of underlying falls
In Scenario 2, the price of the underlying falls, closing at CHF 90 at the end of the term. As a result, the
call warrant expires worthless as the price of the underlying is below
the strike at the end of the term. By contrast, the value of the put warrant increases and amounts to CHF 2 at the end of the term ((CHF 110 — CHF 90) / 10 = CHF 2). Deducting the option price of CHF 1.20 results in a profit of CHF 0.80. This corresponds to net profit of 66.7%. The following chart shows the payoff diagram for the aforementioned put warrant.
Chart 2: Payoff diagram of a put warrant
Influencing factors for the price of a warrant
The price of a warrant is influenced by the same factors as a traditional option. Call warrants profit from a rising underlying, rising volatility and rising interest rates. A fall in the expected dividends also has a positive influence on the call warrant. The price of a put warrant increases with a falling underlying, falling interest rates and rising volatility as well as an increase in the expected dividends.
Table 1: Effects of the influencing factors on the price of a call and put warrant
In practice, it is primarily the price of the underlying, the remaining term and the implied volatility that heavily influence prices.
Table 2: Call warrants on the Nasdaq 100 (as of 13 May 2020: 9082.775) with identical strike but different terms
The effect of the term can be demonstrated very clearly using comparable call warrants on the Nasdaq 100 traded on Swiss DOTS. All warrants have a strike of USD 9000, a multiplier of 1:100 and are listed in CHF. At the time Table 2 was created, the US Nasdaq 100 market indicator was trading at 9082.775 points. The effect of the term is immediately apparent in this table sorted by maturity date. The longer the term, the more expensive the call warrants.
Chart 3: SMI versus volatility
Volatility has a significant influence on performance. Chart 3 compares the performance of the Swiss Market Index with the volatility of the blue chip market barometer. In stable market phases such as that which prevailed in 2019, volatility expressed as a percentage (right-hand scale) generally remains within narrow ranges at a comparatively low level. In the event of strong price movements, particularly sharp price declines, fluctuations increase significantly. The development at the end of February and beginning of March, when the coronavirus crisis led to considerable uncertainty among market players, is an ideal example of such behaviour.
Chart 4: Call warrant multiplied by participating interest vs. underlying, strike and premium in %
Several of the most important aspects can be highlighted once again using Chart 4, which shows a call warrant on the SMI with a term from 4 January 2019 to 19 June 2020, a strike of USD 9000 and a multiplier of 500:1. In the chart, the price of the call warrant is multiplied by a ratio of 500 in each case to make it easier to compare it with the underlying. When the warrant was issued at the start of 2019, the SMI was trading below the strike, which meant that the premium at the time the capital was paid in (IPO) was still around 9%. It then steadily declined in parallel with the rise in the price of the underlying, even slipping slightly into negative territory. As a result of the slump in the SMI between 19 February and 12 March 2020, the price of the underlying briefly fell back below the strike, which resulted in a sharp increase in the premium. This increase was fuelled not only by the decline in the price of the underlying but also by the dramatic rise in volatility. The subsequent recovery in the price of the underlying caused the call warrant to recover markedly. However, this was slightly hampered by the opposite effect of the renewed decline in volatility.
Cash settlement versus physical delivery
Based on the predetermined conditions of a call or put warrant, the underlying is either settled in cash or physically delivered at the end of the term. A cash settlement is generally stipulated in the case of warrants on baskets, indices, currencies, interest rates and commodities. In the case of call or put warrants on individual or a small group of equities, physical delivery of the underlying is possible but rather unusual. The specific delivery conditions can be found in the relevant product term sheet or the associated prospectus.
Hedging with warrants
The process of hedging the payoff of a long position in an underlying is
known as hedging. When hedging the investor purchases a number of put warrants equivalent to the inverse of the delta. In this case, a decline in the price of the underlying would result in an equal increase in the value of the put warrant. As the delta changes over time, the put warrant position must also be continuously adjusted.
Break-even
The term break-even point refers to the underlying price at which
the investor neither generates a profit nor incurs a loss (excluding transaction costs). To calculate the break-even, the warrant price is multiplied by the ratio and added to (when purchasing call warrants) or subtracted from (when purchasing put warrants) the strike.
Total premium / premium per annum in %
The premium is calculated as a percentage of the underlying price and shows how much the price of the underlying has to rise until expiration to reach the break-even point. Using this methodology in the example results in a premium of 15% for the call warrant.
Gearing
Gearing shows how many warrants can be purchased for the
price of the underlying. Although the leverage effect offers the investor significant opportunities, it also carries a high level of risk, as it works in both directions. The gearing is calculated by dividing the price of the underlying by the price of the warrant multiplied by the ratio. Using this methodology in the introductory example results in a value of 20 for the call warrant.
Multiplier
The multiplier shows how many underlyings the investor receives for each warrant he/she holds. The multiplier is exactly equivalent to the inverse of the ratio. In the example at the start of this document the ratio is 10, which means the multiplier is 0.1. As a result, 10 warrants are required to receive one underlying.
Time value and intrinsic value
The intrinsic value depends on the moneyness (in the money / out of the money). If the price of the underlying is above the strike (below the strike for put warrants), i.e. it is in the money, the intrinsic value per warrant is the difference between the price of the underlying and the strike, divided by the ratio. If the price of the underlying is below the strike (above the strike for put warrants), the intrinsic value is equal to zero. The intrinsic value cannot be negative.
The time value is defined as the difference between the market value less the intrinsic value. The higher it is, the more sharply the value of the warrant has to increase before the investor comes out of the red.
Conclusion
Generally speaking, correctly predicting the performance of the underlying over a period defined by the investor is crucial for using a warrant successfully. An investor should have formed an opinion about the performance, the strength of movement and the period in which the expected movement in the underlying will take place before purchasing this type of product. Based on this, he/she can then use the key figures from all the products on offer to select the ideal product for him/her.
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