INTRODUCTION TO WARRANTS This Presentation Should Help You: Understand Why Investors Buy Warrants Learn the Basics about Warrant Pricing Feel Comfortable with Warrant Terminology

Table of Contents

Sample Term Sheet

Scenario Why Buy Call Analysis Warrants?

Warrant Warrant Risk Definitions Pricing Model Measurement

SAMPLE TERM SHEET HSBC Call Warrants Issuer: ABC Investments Co., Ltd Underlying Shares: HSBC (Ticker: 00005.HK) Issue Size: 10 million warrants Launch Date: August 8, 2000 Date: August 8, 2001 Reference Spot Price: HK$105.00 Price: HK$105.00 (100% of the Reference Spot Price) Warrant Price: HK$15.92 (15.2% of the Reference Spot Price) Premium / Gearing: 15.2% / 6.6x Style: European Settlement Date: August 18, 2000 Listing & Listing Date: Hong Kong Exchange, August 18, 2000

WHY BUY CALL WARRANTS?

Leverage Insurance Cash Extraction Trading

Leverage  Higher Percentage Gain on the Upside, but  Higher Percentage Loss on the Downside also

Leverage Insurance Cash Volatility Extraction Trading

Insurance  Call Warrant Costs Less than that of the Underlying Stock for the Same Notional Exposure  Even if the Stock “Crash”’ the Warrant Buyer Can Lose at Most the Initial Premium Paid

Leverage Insurance Cash Volatility Extraction Trading

Cash Extraction  Raise Cash While Maintaining the Same Underlying Notional Exposure by Selling Shares and Purchasing the Same Number of Warrants

Leverage Insurance Cash Volatility Extraction Trading

Volatility Trading  Benefits from Potential Increase in Stock Price Fluctuations

Warrant Price Increases When Underlying Share Price Stock Becomes More Volatile Price

WARRANT PRICING MODEL

Type Stock Price Volatility Dividends Maturity Interest Rates

 : Right (Not the Obligation) to Buy the Underlying Asset at a Predetermined Price on or Before a Specified Date

Asset Price Profit

Strike

Time

 : Right (Not the Obligation) to Sell the Underlying Asset at a Predetermined Price on or Before a Specified Date

Asset Price

Strike Profit

Time

WARRANT PRICING MODEL

Type Stock Price Strike Price Volatility Dividends Maturity Interest Rates

 American Style: A Warrant that Can be Exercised Anytime During Its Life  European Style: A Warrant that Can be Exercised ONLY at Maturity

Type Stock Price Strike Price Volatility Dividends Maturity Interest Rates

 Stock Price Goes Up => Call Warrant Price Goes Up

Type Stock Price Strike Price Volatility Dividends Maturity Interest Rates

 Higher Strike Price => Lower Call Warrant Price Call Put At-The-Money: Stock Price = Strike Price Stock Price = Strike Price In-The-Money: Stock Price > Strike Price Stock Price < Strike Price Out-of-The-Money: Stock Price < Strike Price Stock Price > Strike Price

Type Stock Price Strike Price Volatility Dividends Maturity Interest Rates

 Measure of Stock Price Fluctuations  Higher Volatility Increases the Chance that the Warrant Will End Up Further In-the-Money or Out-of-the Money  Higher Volatility => Higher Call Warrant Value

Lower Volatility Higher Volatility

Type Stock Price Strike Price Volatility Dividends Maturity Interest

Rates

 Cash Dividend Reduces the Stock Price on the Ex-Dividend Date  Higher Cash Dividend => Lower Call Warrant Price

Type Stock Price Strike Price Volatility Dividends Maturity Interest Rates

 Longer Maturity Gives the Warrant Holder a Longer Period to Decide Whether to Exercise the Option

 Longer Maturity => Higher Call Warrant Price

Type Stock Price Strike Price Volatility Dividends Maturity Interest Rates

 Since Call Warrant is a Leveraged Instrument, Higher Interest Rates Increase the Financing Costs and the Buyer Must Pay More for the Call Warrant

 Higher Interest Rates = > Higher Call Warrant Value WARRANT PRICING MODEL Summary: Effects of Changes in Parameters on Warrant Pricing

Call Put Underlying Stock ↑ ↑ ↓ Strike Price ↑ ↓ ↑ Volatility of the Underlying Stock ↑ ↑ ↑ Cash Dividend ↑ ↓ ↑ Maturity ↑ ↑ ↑ Interest Rates ↑ ↑ ↓

RISK MEASUREMENT

Delta Gamma Theta Vega Rho

Delta = ∆Warrant Price / ∆ Stock Price  The Change in Option Price Given a $1 Move in Stock Price  It is also the Number of Shares a Warrant Issuer Needs to Buy Per Call Warrant (the “ Ratio”) to Neutralize the Directional Risk of the Underlying Stock

Delta Gamma Theta Vega Rho

Gamma = ∆ Delta / ∆ Stock Price  Change in Delta Given a $1 Move in the Stock Price  In Real Life Terms, One Can Think of Delta as the “Velocity” and Gamma as the “Acceleration” of a Speeding Car  A Higher Gamma thus Implies a Correspondingly Higher Risk / Reward

Delta Gamma Theta Vega Rho Theta = ∆Warrant Price / ∆ Time  Also Known as “Time Decay”  Measures the Reduction in Option Price Each Day

Delta Gamma Theta Vega Rho

Kappa or Vega = ∆Warrant Price / ∆ Volatility  Change in Warrant Price Given a 1% Change in Volatility

Delta Gamma Theta Vega Rho

Rho = ∆Warrant Price / ∆ Interest Rate  Change in Warrant Price Given a 1% Change in Interest Rates  Affects Long-Dated Options (Longer Than 1 Year) Significantly More Than Short-Dated Options

WARRANT DEFINITIONS

Premium Gearing Leverage Intrinsic Time Value Covered vs. Warrant

Value Company Multiplier Warrant

Premium = Call Warrant Price – (Stock Price – Exercise Price) Stock Price

 The Break-Even Level at Maturity in Order for the Warrant Buyer to Recover the Original Cost of the Option.  Example: a 5% Premium Means the Stock Price will Need to Increase by 5% at for the Buyer to Break-Even on His Original Investment

Premium Gearing Leverage Intrinsic Time Value Covered vs. Warrant

Value Company Multiplier Warrant

Gearing = Stock Price / Warrant Price

 The Dollar Value of the Stock Controlled by One Dollar Worth of Warrant  Gearing is Not the Same as Leverage

Premium Gearing Leverage Intrinsic Time Value Covered vs. Warrant Value Company Multiplier Warrant

Leverage = Gearing X Delta

 The Percentage Change in Warrant Price Given a 1% Move in Stock Price  Example: 3 Times Leverage Means the Warrant Price Will Go up Roughly 3% for a 1% Increase in the Underlying

Premium Gearing Leverage Intrinsic Time Value Covered vs. Warrant

Value Company Multiplier Warrant

Intrinsic Value  Measures the “In-the-” of the Warrant  Call Intrinsic Value = Max (0, Stock Price – Strike Price) Put Intrinsic Value = Max (0, Strike Price – Stock Price)  Warrant Price = Intrinsic Value + Time Value

Premium Gearing Leverage Intrinsic Time Value Covered vs. Warrant Value Company Multiplier Warrant

Time Value = Warrant Price – Intrinsic Value

 Value of the “Right” to Exercise the Warrant in the Future  Rarely Less Than Zero Before Expiration Since the Right to Exercise is Worth Something  In Most Cases, a Warrant Holder is Better Off Selling Rather than Exercising the Warrant Early, Even if it is In-the- Money

Premium Gearing Leverage Intrinsic Time Value Covered vs. Warrant

Value Company Multiplier Warrant

 Covered Warrant: A Warrant Issued by a Third-Party Issuer, Such as a Merchant Bank. Such a Warrant Does Not Change the Capital Structure of the Company on Which the Warrant is Issued.  Company Warrant: A Warrant Issued by the Underlying Company Itself, Usually as Part of a Fund Raising Exercise. Such a Warrant Enlarges the Capital Base of the Company.

Premium Gearing Leverage Intrinsic Time Value Covered vs. Warrant Value Company Multiplier Warrant

 Number of Warrants That Has to Be Exercised in Order to Receive One Share of Stock  Example: A Multiplier of Ten Means That Warrant Holders Have to Exercise Ten Warrants to Receive One Share of the Underlying Stock

SUMMARY  Investors Buy Warrants for 4 Main Reasons:  Leverage, Insurance, Cash Extraction, Volatility Trading

 Warrant Pricing Model Requires 7 Basic Inputs:  Type, Stock Price, Strike Price, Volatility, Maturity, Interest Rates, Cash Dividends

 A Warrant’s Risks Can Be Measured by the 5 “”  Delta, Gamma, Theta, Kappa or Vega, Rho

 7 Commonly Used Terms in the Warrant Market  Premium, Gearing, Leverage, Intrinsic Value, Time Value, Covered vs. Company Warrants, and Warrant Multiplier