Warrant

From Traderpedia

Definition:
A security that gives the holder the right to buy, and in some cases sell, an underlying instrument at a fixed price.


The underlying securities can be shares, baskets of shares, commodities, international currencies or indices. The act of using the right given by the warrant is referred to as "exercise". Warrants are classified as either American or European style, meaning that they can be exercised at any time during the life of the warrant (American style) or only on the expiry date (European style).

Warrants are part of the family of securitised derivatives as their value depends on the value of the underlying security. As such, the warrant investor gains economic exposure to this underlying security without actually owning it.

Warrants cost a fraction of the price of their underlying security and give the buyer the right (but not the obligation) to buy (a call warrant) and in some cases sell (a put warrant) this underlying security at a predetermined price (the strike, or exercise price) on or before a predetermined date (the expiry, or completion) date.

Simplified example of a call warrant

Imagine that a certain call warrant carries the right to buy one share of EK1 Ltd. at 110p, the current share price is 100p and the current warrant price is 5p. If the share price rises to 130p (a 30% gain) the warrant might rise to at 20p (a 300% gain).

In the above case, a 30% increase in the share, results in a 300% increase in the warrant - this is the effect of gearing, or leverage.

Simplified example of a put warrant

Imagine that a certain put warrant carries the right to sell one share of EK1 Ltd. at 90p, the current share price is 100p and the current warrant price is 5p. If the share price falls to 60p (a 40% loss) the warrant might rise to 30p (a 500% gain).

Contents

[edit] Corporate and covered warrants

UK warrants can be divided into corporate and covered, with the main differences outlined below:

Corporate warrants Covered warrants
Issued by company over its own shares Issued by bank or institution over other assets
New shares issued upon exercise No new shares issued
Call warrants only Call, put and exotic warrants
Maturities typically several years Variable maturities
Restricted liquidity Good liquidity
Established product Recently introduced
Static market Fast growing market

This article is mainly concerned with covered warrants, although some of the principles outlined apply to both types.

[edit] Advantages of warrants

NB Many of these advantages and disadvantages will only apply to covered warrants and not their corporate counterparts.

[edit] Gearing/leverage

In general, the gearing property of warrants means that price changes in covered warrants will exaggerate movements in the underlying assets. Gearing is the primary attraction of warrants. Buying warrants rather than the underlying assets directly means that you can gain access for a lower entry cost.

[edit] Example

If some shares are 100p and a warrant carries the right to buy the shares at 80p, then the warrants might trade at 20p (assuming a zero premium for simplicity). A 20% rise in the shares from 100p to 120p means that the warrants must be worth at least 40p - a 100% increase.

[edit] Unlimited gains, limited losses

The combination of limited losses with unlimited gains for call warrants constructs a powerful argument. If you invest £1000 in warrants then no matter how badly your investment turns out, you cannot lose more than £1000. Your loss is limited to the money you put in. It is a first-rate feature of warrants that your maximum loss is known in advance, unlike, say, CFDs and spread betting.

[edit] Accessibility

To deal in warrants you simply need to ask your stockbroker - no new account is required. It is not difficult to get started, especially if you are already used to trading in shares - warrants essentially work in the same way, with largely the same method of dealing.

[edit] Transparency

The covered warrant market has the considerable benefit of transparency. You can see what is going on, which means you can also see whether you are getting a fair deal. This is not always true in other markets. If you are taking out a spread bet, for example, you do not know that you are dealing at the best price the market has to offer because there is no central trading platform. In contrast, the centralised listing and trading arrangements for covered warrants mean that all prices are very easily accessible to enable a full comparison and choice. The market is fully transparent, right down to the reporting requirements which mean that trades must be reported within three minutes.

[edit] Good liquidity

In the case of covered warrants, liquidity is not a problem because the issue sizes are large and because the pricing system is established with the issuer in a facilitative role. Corporate warrants, however, do not generally enjoy good liquidity.

[edit] Low transaction costs

The costs of dealing in warrants, especially covered ones, are not high. Opening an account and dealing costs are as low as that for shares as stockbroking is a highly competitive market. But the big attraction for cash-settled covered warrants is that they will be free of the annoying 0.5% stamp duty levied on share trading.

[edit] Tight bid-offer spreads

Pleasing though the absence of stamp duty is, it pales into insignificance alongside the dealing spread, which is a far larger component of the overall cost of dealing. For covered warrants, maximum spread rules will be applied to warrants traded on the order book, either the greater of 10% on the bid price or 1p, but in practice dealing spreads are likely to be far narrower.

[edit] Designed as a retail product

Covered warrants have been specifically designed for private, or in the industry parlance, retail investors. Private investors are welcome and are in no way treated as secondary to institutional investors. This is a realm in which private investors really matter. Clients will be wooed by the issuers and protected by the regulators, and for many smaller clients this makes a refreshing change.

[edit] Opportunities in bull and bear markets

Using put warrants as well as call warrants means that certain warrants can prosper in bear markets as well as bull markets.

[edit] Aid to diversification

For smaller investors, the lower price of covered warrants can be used to help portfolios become more diversified.

[edit] Example

An investor with £5000 to invest in shares may decide that £1000 is the minimum efficient investment in each. The resulting portfolio of five shares will necessarily be concentrated and vulnerable to poor performance if the selections prove to be unfavourable. Using covered warrants, the same exposure to those five shares could perhaps be achieved by an investment of £2000 in total, or £400 per warrant. This allows the balance of £3000 to be used for further purchases which may broaden the sector or geographical base of the portfolio, lessening the dependence on individual stock performance and reducing overall volatility.

[edit] Ability to invest in assets otherwise unavailable

Warrants can also improve your investment reach. Using covered warrants listed on the London Stock Exchange investors have the ability to play all kinds of markets and views, some of which were previously too difficult or expensive to consider. This is particularly true for covered warrants which have been issued on currencies, commodities, baskets of shares, and overseas instruments.

[edit] Stock exchange listing

Warrants are listed on the London Stock Exchange and traded according to its rules. This unmatched legitimacy is a comforting background for investors risking capital by investing in geared products. It is a huge advantage over competing instruments such as spread betting as investors can feel confident that the LSE will maintain orderly markets with properly maintained bid and offer prices and spreads during good times and bad.

[edit] Provision of information and education

Covered warrant issuers make their money from margin built in to the premiums and dealing spreads, and if the market fails to thrive then it fails commercially. They have every incentive to support the market and to ensure as far as they can that investors understand the market, enjoy their trading, make good profits, tell all their friends, and come back for more. This is why issuers are eager to promote the market with advertising, articles, guides, seminars, web sites, and other promotions to attract investors.

One huge advantage of the new market is that it is served by some very sophisticated data providers. Not only is data provided, but some sites allow the data to be manipulated to simulate certain outcomes. Web sites are being developed all of the time, so any comment is bound to become out of date, but for now one really nice feature to be found on some sites is a warrant simulator which allows users to change certain variables and to see in real-time how these might affect warrant prices.

[edit] Disadvantages

[edit] Complexity

Covered warrants can be a complex product. Ther are certainly not as simple as shares, or even as traditional warrants, and can be confusing to the novice. When you buy a share you are buying a slice of a company, which is an easy concept to understand. Derivatives are by their nature less straightforward, deriving their value from another instrument and therefore being one extra step away from the profits, assets, and true value of a company.

[edit] Adverse price movements

As geared instruments they have the capacity for very quick and dramatic price movements which can easily catch you out if they go the wrong way.

A small change in the price of an underlying asset, or perhaps no change at all, can lead to a substantial decline in the value of covered warrants. Market timing can be very important, and if you get it wrong then the results can quickly become painful. Warrants are by no means buy-and-forget instruments. When things go wrong the performance can turn very nasty very quickly, and the result can be a total loss of the money invested.

[edit] Premium

There is a price to pay for the many advantages which covered warrants confer, and that price is the premium. This is the extra amount in the warrant price beyond the value which it would have if it were to be exercised immediately, and the premiums can on occasions be very high.

[edit] Limited life

Many investors have a few stale long-term holdings in their portfolios which were once-great ideas which did not quite work out. With shares, unless the company actually goes bust, there is always the option to hold for the long-term and to hope for the best. Because covered warrants have a finite defined life, this possibility is removed. In many cases warrants is issued with a life of just one year, and at the end of that year, the warrant will expire, either with some intrinsic value, or no value at all.

For this reason covered warrants are often approached with a trading mentality, and many investors enjoy the cut-and-thrust of regular dealing which is made possible by the excellent liquidity and dealing spreads. For long-term investors though, individual covered warrants are generally unsuitable as they do not offer much in the way of longevity.

[edit] Time value decay

Premium (or time value), disappears as warrants approach their final expiry date, which means that if the underlying asset stands still, the associated warrants will fall in value, whether they are calls or puts. Dull markets are not welcome. This in-built requirement for the underlying asset to move in the right direction is a drawback, as is the slow drip of the time value disappearing.

[edit] Absence of price anomalies

Traders in the traditional equity warrants market can sometimes enjoy the fact that the market is small, overlooked, and illiquid. These features mean that price movements are far from uniform and that anomalies frequently arise. The pricing system for covered warrants, where supply and demand are less important factors, means that anomalies, price dislocations, and stickiness will seldom arise. This is a pity in some respects, but it should be noted that the price anomalies in the equity warrant market only arise because of the illiquidity, which can be a high price to pay.

[edit] No income

Normal trading warrants do not rank for any income. They do not qualify for dividends paid on underlying shares, which in the case of higher yielding assets can be a considerable drawback. If you do require income from your securities investments then you will need to consider what proportion of your portfolio might be allocated to warrants, if any.

[edit] No shareholders' rights

The value of a warrant may be based on a company's shares, but as covered warrant holders are not linked directly to that company, they rank for none of the rights which shareholders enjoy. Covered warrant holders have no voting rights, will not receive annual or interim reports, and will not qualify for any shareholders' perks which may be on offer.

[edit] Need to have online access

Covered warrants are complex, which means there is a need to disseminate a lot of information - not just the price. It is difficult to perceive how this could be done through traditional print media, and the issuers are certainly set up to deliver a range of services and information electronically. A considerable bulk of information is on the internet, and the internet only. This is partly a practical matter - just consider the amount of space required otherwise to provide a decent amount of information on the new issues. On a busy day in UK 100 new warrants can be issued, all with detailed term sheets. If you do not have internet access, or at least access to e-mail, you may be at a considerable disadvantage. It will not preclude you from participating in the new market by any means, but there might be a constant nagging doubt as to whether you are really as informed as you could be.

[edit] Capital gains tax

The taxation position of covered warrants appears on both sides of this chapter. The absence of stamp duty is an advantage over shares, but the imposition of capital gains tax (CGT) is a disadvantage when covered warrants are compared with one of their closest rivals: spread-betting. Covered warrants, as securities, will be treated by the Inland Revenue in the same way as shares as far as CGT is concerned, though this does mean that losses are tax deductable.

Individual warrants do not at present qualify for inclusion in an ISA, although an authorised warrant fund may be eligible.

[edit] Credit risk

When you buy a covered warrant, you are doing so on the understanding that the issuer will honour its terms and provide the relevant payout at the end of its term. The issuer is your market counterparty. There is a (seemingly very small) risk of an issuer defaulting and failing to keep up its end of the deal.

Whilst this is unlikely to occur, given the regulatory requirements for the financial strength of the banks authorised to issue warrants, investors have learned never to say never.

[edit] Trading warrants

Warrants can be traded through a number of ordinary execution-only stockbrokers, as per ordinary shares.

The key information you need will generally fall into nine elements:

1. The underlying asset
2. The name of the issuer
3. Type of warrant (call or put)
4. Sub-type and terms for exotic warrants
5. Strike or exercise price
6. Cover ratio (eg 1:1 or 10:1)
7. Final exercise date
8. Extra information about how final price is calculated (close, last trade etc.)
9. Gearing level

The basic information for any warrant is to be found in the term sheet which is published at the time of issue, or you can generally obtain this material from a list on the issuer's web site.

[edit] Cover ratio

The number of warrants required to exercise into one share, or its cash equivalent, could as easily be 0.5, 5, 10, or 100 as it could be one. This is frequently called the cover ratio, although it is also called the subscription ratio, the exercise ratio, the conversion ratio, the entitlement ratio, the parity ratio, the multiplier, the set, or just the plain ratio. If 50 warrants are required to exercise into one share, the cover ratio is 50, or 50:1.

Cover ratios are rarely 1:1 for index warrants, nor for other securities which have a high absolute price. The purpose of 5:1 or 10:1 cover ratios is to reduce the covered warrant price down to an easily marketable and tradeable level.

[edit] Gearing

The gearing of a warrant (or parcel of warrants) is a measure of the number of underlying securities to which exposure is gained by purchasing one warrant (or parcel of warrants). It is calculated as follows:

Price of underlying / (price of warrant x cover ratio)

Remember, with high gearing a small move in the underlying is likely to cause a large one in the warrant price.

[edit] Central warrants trading service (CWTS)

Not all covered warrants in London are traded in the same way, although to an end-user investor the difference is minimal. A limited number of warrants use the Central Warrants Trading Service (CWTS) platform, or order book, which provides for fully-automated trading. This is a new segment on SETS, the exchange's electronic order book. This service provides continuous execution which means that two-way prices are continuously quoted, and a broker simply executes against the bid or offer as desired. You can check the price at any time and deal instantly.

[edit] Retail service provision

Covered warrants trading can also take place outside the CWTS order book via Retail Service Providers (market makers). Covered warrants can be listed, but have their prices displayed through other mechanisms, and this is the function of RSPs or the RSP Gateway system which is used by stockbrokers.

This RSP system for covered warrants does not offer automatic execution, but is a quote request system where an indicative quote are displayed but the principal (or market-maker) is not obliged to deal until a quote is requested. Trading can also be conducted over the phone as you might expect.

[edit] Exercising warrants

Most covered warrant investors will never exercise a warrant. Whilst the value of all warrants is derived from their exercise terms, the majority of trades occur within warrants' lives, with investors trading in and out and taking their profits or losses before the final maturity date.

Unless your aim is to buy the underlying investment, in the case of physically-settled corporate warrants where the exercise price is paid in exchange for the asset, it will rarely be in your interests to complete the exercise notice and stump up the extra cash.

[edit] Cash settlement

All of UK covered warrants are cash-settled rather than stock-settled. This means that the issuer pays a cash amount for the intrinsic value of the warrants at the expiry date, or on exercise, if sooner. In other words, although the terms of call warrants are usually expressed as a right to buy, and put warrants as a right to sell, they are more accurately a right to receive a cash payment equivalent to the difference between the exercise price and the value of the underlying asset at expiry.

[edit] Example

Investor holds 5000 warrants with right to buy one share at 100p. At final maturity date, shares close at 140p. Cash settlement = (share price - exercise price) * number of warrants. Cash settlement = 40p * 5000 = £2000.

[edit] Warrant pricing

In deciding what the fair price is, the issuer will take a number of factors into account in the pricing model. Price determination is a sophisticated process which is largely undertaken using algebraic techniques and computer models. The five principal inputs are the asset price, volatility, time to expiry, dividend yields, and interest rates.

The most important, but not the only, determinant will be the underlying asset price, which for call warrants will push the price of the warrants higher as the asset rises - they will move in the same direction, other things being equal. For put warrants the prices should move in opposite directions.

The price of a warrant is made up of two components, known as the intrinsic and the time value of the warrant.

[edit] Intrinsic value

The intrinsic value of a warrant is sometimes referred to as the minimum value of the warrant and is calculated in the following manner:

For a call warrant:

Intrinsic value = underlying security's price - exercise price of the warrant (cannot be negative).

For a put warrant:

Intrinsic value = exercise price of the warrant - underlying security's price (cannot be negative)

Warrants are said to be out-of-the-money, at-the-money or in-the-money according to whether they have intrinsic value. If a negative value is obtained when the above formula is applied, the warrant in question is said to have no intrinsic value and is termed "out-of-the-money".

  • If the underlying security is trading at the exercise price of the warrant, the warrant is said to be "at-the-money".
  • If a positive value is obtained from the intrinsic value, the warrant is said to be "in-the-money".

[edit] Time value

However, warrants which have no intrinsic value will usually be worth something on market prior to expiry. This is the time value component of the warrant's price and is calculated as follows:

Time value = market price of the warrant - intrinsic value.

This time value component takes into account the factors described in this chapter and represents the price paid for the possibility that the warrant will finish either in-the-money or more deeply so. Obviously, this possibility decreases with the passage of time and so warrants' time value is eroded. This phenomenon is known as "time decay" and accelerates as the warrant nears expiry.

Hence, the time value of a warrant corresponds to the level of probability that it will finish in-the-money or more deeply so - i.e. "highly likely", "possible", "improbable". Contrary to a classic long position in the underlying security, where returns are made when the security moves in the anticipated direction, profitable warrant investment involves being right on two accounts: the direction of movement in the value of the underlying security and the timing of this move. These aspects are taken into account when determining the price of a warrant.

[edit] The exercise price and the market value of the underlying security

The market value of a warrant at expiry should equal its intrinsic value. In general,the value of a call warrant will increase as the price of the underlying security increases and the value of a put warrant will increase as the price of the underlying security decreases. As such, a warrant will appreciate in value the more it moves into-the-money.

[edit] Expiry and the passage of time

The expiry remains fixed during the life of the warrant. In general, the greater the period to expiry, the more expensive the warrant will be. However,with the passage of time, the level of probability that the warrant will finish in-the-money or more deeply so decreases and the value of the warrant decreases accordingly. The choice of expiry is therefore an important element in the investment decision-making process. However, the value of a longer-dated warrant will resist time decay better than a shorter-dated warrant,as shown in the graph below:

[edit] Volatility

Volatility is one of the most influential factors on a warrant's price, yet the hardest to understand. Defined simply, volatility is the measure of the price fluctuations of the underlying security. The historical volatility gives an indication of the way an underlying security behaved in the past and can be calculated by taking the annualised standard deviation of the return of the underlying security measured at regular intervals. However,when pricing a warrant, one must take into consideration the volatility anticipated by the financial markets for the life of the warrant, referred to as "implied volatility". Generally, for both calls and puts, the higher the implied volatility level, the more expensive the warrant.

In addition, implied volatility levels can move dramatically when sharp market corrections occur or in times of political instability,etc. Hence,the price of the warrant can vary even if the value of the underlying security remains unchanged as a result of the sensitivity of the warrant's price to changes in implied volatility levels.

In terms of risk, high volatility means a symmetrical risk (rise or fall) for the investor who has purchased the stock. However,for the warrant investor, the risk is limited on the downside to the premium paid while the upside exposure can be unlimited.

[edit] Dividends

The warrant price will be affected by changes in the market's expectations of the dividends due on the underlying instrument. In general,the higher the dividend yield expected, the lower the price of calls and the higher the price of puts.

[edit] Interest Rates

From a financial point of view, buying a warrant is comparable to buying (call warrant) or selling (put warrant) the underlying security on margin. As a result, a rise in interest rates will generally bring about a rise in the price of a call warrant and a drop in the price of a put warrant.

[edit] The Greeks

As previously discussed, the price of the warrant (and indeed an option) results from the interaction of six parameters: the exercise price, the price of the underlying security, the maturity, the dividend yield, interest rates and implied volatility. These quantifiable factors are the input variables used in theoretical pricing models such as Black-Scholes. As there are many forces affecting the warrant's value, prices can change in ways which may surprise even the most experienced trader. It is therefore necessary to understand how changing market conditions are likely to affect a warrant's theoretical value.

Fortunately, along with the theoretical value, pricing models also generate sensitivity coefficients which enable investors to assess not only the direction of the resulting change but also its relative magnitude. It is important to bear in mind that several parameters can be changing at the same time. As a result, these coefficients give data which suppose that all other parameters remain constant. These coefficients have been assigned Greek letters: delta, gamma, theta, vega and rho.

[edit] Delta

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[edit] Gamma

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[edit] Theta

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[edit] Vega

[edit] Rho

[edit] Trading strategies

[edit] Speculation

[edit] Hedging

[edit] Delta neutral hedging

[edit] Cash extraction

[edit] Related T2W Resources