INTRODUCTION TO WARRANTS This Warrant 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 Maturity Date: August 8, 2001 Reference Spot Price: HK$105.00 Exercise 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 Option Style: European Settlement Date: August 18, 2000 Listing & Listing Date: Hong Kong Stock Exchange, August 18, 2000
WHY BUY CALL WARRANTS?
Leverage Insurance Cash Volatility 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 Strike Price Volatility Dividends Maturity Interest Rates
Call Option: Right (Not the Obligation) to Buy the Underlying Asset at a Predetermined Price on or Before a Specified Date
Asset Price Profit
Strike
Time
Put Option: 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 “Hedge 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 Expiration 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-Moneyness” 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 “Greeks” 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