1. Leverage
a. Definition:
i. Leverage expresses the relationship of the warrant price to the price of the underlying instrument.
ii. Leverage= So / warrant price x conversion ratio
iii. For “deep in the money” warrants, leverage can be used as an indicator for the expected (stronger) price change in the underlying (share) price, given a 1% change in the underlying (share) price
iv. Unfortunately, many investors still use leverage as their exclusive indicator when choosing warrants. Although this makes sense for deep-in-the-money warrants, delta and effective gearing are more suitable valuation indicators for out-of-the-money or at-the-money warrants.
2. Delta
a. Definition:
i. From a mathematical perspective, delta factor is the first derivative of the warrant price by the price of the underlying instrument.
ii. It indicates the change in a warrant’s theoretical value, in absolute terms, given a one-unit change in the price of the underlying.
iii. Multiplying delta by the change in the price of the underlying – taking account the conversion ratio – indicates the theoretical change in the warrant price.
3. Effective gearing
a. Definition:
i. Contrary to the leverage indicator, which is based on the assumption of a parallel (absolute) change in the prices of the warrant and the price of the underlying, effective gearing takes the delta into consideration. It therefore provides a measure of the actual leverage effect provided by the warrant.
ii. This helps to avoid mispricing which might occur due to purely focusing on leverage, especially for warrants that are deep-out-of-the-money
iii. Effective gearing = delta x leverage
4. Theta/ Time to maturity
a. Definition:
i. Theta describe the effect of a change in the remaining lifetime on the warrant price
ii. It expresses the change by one day or one week
iii. The theta – which always has a negative sign – is a daily or weekly indicator
iv. Warrants that are deep-in-the-money have a low theta because they have high intrinsic value and a relatively low time value component. Similar to warrants which are out-of-the-money, their time value tends to fall on rapidly to the end of maturity
v. Theta is highest for at-the-money warrants, where the time decay can be enormous, especially as such warrants approach expiration.
vi. “ The life time of the warrant should be at least 3 months longer than the timeframe during which the investor expects the price of the underlying to change “
5. Rho/ Interest rate
a. Definition:
i. Rho describe the effect of a change in interest rates on the warrant price
ii. The term of a call warrant usually specify that the issuer bank is obliged to make a cash settlement of the intrinsic value of the warrant at expiration. The bank typically purchases the underlying instrument when the warrant is issued so as to manage its obligations under the warrant. It therefore holds a position, which it normally finances on the money market over the entire lifetime of the warrant.
iii. Since the interest costs incurred would be factored into the price of the warrant, a call warrant becomes cheaper of the interest rate fall and more expensive of they rise
iv. As an issuer of a put warrant, the issuer bank typically sells the underlying to hedge its warrant position, since it is obligated to give the investor a cash payment reflecting the intrinsic value of the warrant at expiration.
v. As the bank would include in the price of the put warrant the proceeds resulting from the sale of the underlying a put warrant becomes cheaper if money market rates rise and more expensive if they fall
vi. Rho expresses the change in the warrant price, given a one percent change in interest rates. The indicator is always between 0-1 for a call warrant, and between 1-0 for a put warrant. The impact of financing costs on the warrant price decreases with a shorter remaining lifetime. Consequently, Rho declines towards expiration.
6. Vega/ Volatility
a. Definition:
i. It only measure the magnitude of the fluctuation
ii. The higher the volatility, the higher the price of the warrant
iii. Historical, implied and future volatility
iv. Historical volatility is based on the price data of the past
v. Implied volatility reflected in current option prices. A bank’s warrant trader uses current warrant prices to compute and assess implied volatility. Implied volatility is critical for the pricing of warrants. Even the best warrant traders cannot predict a warrant’s future volatility, since future data is an unknown quantity. Besides the price of the underlying, volatility is the most important factor influencing the value of warrant
vi. Vega is the indicator reflecting the effect of fluctuation in the implied volatility on the warrant price. Vega indicates by how much the option price will change given a 1% point change in implied volatility.
vii. A Vega of 0.3 means that if the volatility of the underlying price changes by 1% point, the value of the warrant rises/ falls by 0.30 currency units, adjusted for the conversion ratio. Looking at a warrant that is trading at a price of S$0.5 and has a conversion ratio of 10:1, a one percentage point rise in the implied volatility means the warrant will rise to $0.53
viii. Vega is always positive and is calculated in the same way of call and put warrants. Investors beware: the implied volatilities of warrants are high when the market underlying prices have fallen sharply.
ix. This is because downward trends are often faster and more pronounced than upward trends. Hence, it can happen that the positive rise in the price of the underlying for call warrant sometimes is offset by the loss in implied volatility of the warrant and the price of the call will not increase. Investor should therefore always check for a sound relationship between historical and implied volatility. Warrants on the same underlying, with comparable lifetime and exercise price have different implied volatilities, the warrant with the lowest implied volatility should be chosen, taking into account the bid/ask spread and the issuers’ credit quality
7. The spread
a. Definition:
i. In contrast to equities or bonds, where the market liquidity (supply and demand) has immediate impact on the exchange price of the respective instrument, the pricing of structured warrant is not dependent on traded volumes.
ii. Issuers adapt their pricing to the price development and volatility of the underlying instrument, and the warrant’s lifetime.
iii. The size of the bid/ask spread can, of course, be affected by the market liquidity of the underlying: in the case of a wider spread in the underlying instrument, issuers are faced with higher hedging costs which they will factor into the pricing of related warrants.
iv. Having said that, issuers define a maximum bid/ask spread when listing structured warrants.
v. In conclusion, whether or not a particular warrant is actively traded does not have a significant impact on the pricing of structured warrants
vi. The wider the bid/ask spread set by the issuer, the bigger the underlying price change required to get into the profit zone
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