Warrants are fast becoming an essential part of any investor’s portfolio since they can make money whether the market is rising or falling. David Lake provides a guide to these useful financial tools.
Traded on a stock exchange in the same manner as shares, warrants are powerful and transparent investment tools. They can enable investors to maximise financial returns while strictly limiting potential losses. Put warrants also give investors the opportunity to make money even when markets are falling.
Warrants have been traded in the main European financial markets for more than a decade. The three largest European warrant markets of Germany, Switzerland and Italy witnessed more than Ł30bn of warrant trading volume in 2002. Many investors now regard warrants as an essential part of their portfolio.
Warrants are part of the derivatives family, as their value depends on the value of an underlying security. This can be a share, a basket of shares, a commodity, an exchange rate or a price index. Warrants are geared instruments, which means that a warrant investor can gain economic exposure to an underlying security with less capital invested than an equivalent investment in the security itself.
Covered warrants are long-dated options. That is, a warrant is a financial instrument that gives the holder the right, but not the obligation, to buy (for calls) or sell (for puts) a defined quantity of a specified underlying security at a predetermined price (the strike or exercise price of the warrant) on a certain date in the future (the expiry).
For a call warrant, the more the price of the underlying security exceeds the exercise price of the warrant, the larger the cash payout will be. This makes call warrants attractive to investors who believe that markets will rise. For a put warrant, the further the price of the underlying security falls below the exercise price of the warrant, the larger the cash payout will be. This makes put warrants attractive to investors who believe that markets will fall.
Speculative instruments
When an investor expects a security to rise, the most natural reflex is to buy it. However, if the forecast turns out to be wrong, the investor pays for its entire decline. A call warrant allows investors to take advantage of a rally (or a decline) while limiting their loss to the amount paid to buy the warrant. This leverages the investment: whereas direct investment in the underlying security pays 1%, investment in warrants can offer a performance of 3% to 4%.
Covered warrants can either be physically settled (ie, the holder takes physical delivery of shares at expiry) or, more commonly, cash settled. In this case, if held to expiry, a cash payout is made based on the difference between the price of the underlying security at expiry and the exercise price of the warrant. The minimum payout in each case is zero – ie, the maximum loss on a warrant trade is the initial amount invested.
Profitable moves
It is important to note that to benefit from a positive move in the underlying security, you do not need to hold a warrant until expiry. Throughout its life, the price of a warrant moves in line with the underlying security on which it is based on a second-by-second basis. This means that profits can be taken or losses can be cut at any time. As a geared instrument, the warrant price magnifies the movements in the underlying security; far higher returns are therefore available by trading the warrant than by trading the underlying security itself.
The price of a warrant before expiry is determined by the issuer using a standard options calculator. Although the calculation itself is complicated (based on a pricing model such as Black & Scholes), the principal is straight forward. There are three key variables which affect the warrant’s price: the price of the underlying security, the time to expiry and implied volatility. The dividend yield and the level of interest rates will have a relatively minor impact on the value of warrants compared with the other variables.
Underlying price
The impact of movements in the price of the underlying security (the spot price) on the warrant price is straight forward (See figure 1). Hence call warrants are attractive to bulls (who believe markets will rise) and put warrants attractive to bears (who believe markets will fall). However, investors need to be aware of other factors that can affect a warrant’s price prior to expiry.
Intrinsic value
The price of a warrant is theoretically made up of two components: the intrinsic value and the time value. The intrinsic value of a call warrant is equal to the difference between the price of the underlying security and the exercise (strike) price of the warrant, if this is positive, or zero, if not.
So, for example, a call warrant on Barclays with a strike price of 400p and a current share price of 450p would have an intrinsic value of 50p. If the price of Barclays fell to 390p, the warrant would have zero intrinsic value.
Conversely, the intrinsic value of a put warrant is only positive if the price of the underlying is below the strike price of the warrant, in which case intrinsic value is equal to the difference between the strike price and the spot price. Otherwise the put warrant has no intrinsic value.
Time value – when to sell?
A warrant that has no intrinsic value will still be worth something in the market prior to expiry. This component is called the time value of the warrant. This represents the price paid for the possibility that the warrant will finish in-the-money.
It is now clear why it is not in the interest of a warrant holder to exercise an American-style warrant (which is exercisable at any time up to and including the expiry date – as opposed to a European-style warrant, which can only be exercised on the expiration date) early, as all they will receive is the intrinsic value of the warrant. Only by selling the warrant in the market will they receive its full value.
The probability that any particular warrant will expire with a higher positive value decreases with the passage of time, as the underlying security has less opportunity to move in a favourable direction.
Similarly, the time value of a warrant is eroded as expiry approaches, and is zero at expiry itself. This phenomenon is known as “time decay”. Time decay for a warrant does not reduce in a straight line. Instead, it accelerates rapidly as the warrant nears expiry.
The choice of expiry is clearly an important element in the investment decision-making process for warrants. 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.
Volatility
Volatility is one of the most influential factors on a warrant’s price. Defined simply, volatility is a measure of the frequency and amplitude of price movements in the underlying security.
Historical volatility gives an indication of the way an underlying security has behaved in the past. However, when pricing a warrant, one must take into consideration the volatility anticipated for the underlying security for the remaining life of the warrant. This anticipated level is used when pricing warrants and is referred to as ‘implied volatility’.
Generally, for both calls and puts, the higher the implied volatility level, the more expensive the warrant. Bearing in mind the fact that the price of a warrant is a reflection of the probability the warrant will expire in-the-money, this makes intuitive sense.
It is possible that the markets’ view on the future volatility of a particular security (the implied volatility) will change during the warrant’s lifetime – for example, if a company announces a change of business focus. If this happens then the price of the warrant may change, even if there is no movement in the underlying security itself.
The movement in the warrant price may be positive or negative depending on whether the impact of the event is expected to increase or decrease future volatility in the stock price.
Figure 2 summarises the impact of a decrease in a given pricing parameter on a warrant’s price.
Investors can hedge a portfolio with index put warrants; they can act as an insurance policy because they effectively guarantee a minimum value for a portfolio or underlying security. This is equal to the exercise price of the warrant. Should the market fall, the value of the portfolio will decrease. However, this loss can be either partially or fully offset by the appreciation in value of the put warrants.
It should be noted that for warrants on non-domestic underlying securities (such as Nasdaq 100 or the Bombay Stock Exchange Index), a further variable affecting the warrant price is the exchange rate that converts the price of the warrant into local currency. This may have a net positive or negative effect.
David Lake is head of UK listed products
