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What determines the price of a warrant?
Warrant prices are affected by several different factors. We discuss below the 3 main factors which are important for the warrant investor to understand:
1. Level of underlying versus the Strike Price
The value of a warrant is a combination of intrinsic value and time value. The
intrinsic value is the difference between the price of the underlying asset and
the strike price. It represents profit obtained upon exercise. From this notion,
concepts such as at-The-Money (ATM), in-The-Money (ITM) and out-of-The-Money
(OTM) are derived.
2. Time Value
Time value reflects the probability of a favourable move in the underlying asset
price before maturity (up for a call, down for a put). Warrants lose time value
as they approach maturity. This is because the chance for the reference spot
price to exceed (for a call) or fall below (for a put) the strike price of the
warrant diminishes as time passes by, assuming all other parameters remain the
same.
Theoretical value of a warrant = intrinsic value + time value
Example:
SG Company C call warrant
(stock code: 9905.HK) as of 1 Aug 2000
Company C share price: HKD 102.50
Strike price: HKD 95.00
Warrant price: HKD 1.63
Intrinsic value: HKD 0.75 = (HKD 102.50 - HKD 95.00)/10
Time value: HKD 0.88 = (HKD 1.63 - HKD 0.75)
Warrants lose time value as they approach maturity. This is because the chance for the reference spot price to exceed (for a call) or fall below (for a put) the strike price of the warrant diminishes as time passes by, assuming all other parameters remain the same.
Example:
SG Company C call warrant
(stock code: 9905.HK) as of 1 Aug 2000
Company C share price: HKD 102.50
Strike price: HKD 95.00
Maturity: 19 Feb 2001
3. Volatility
Volatility is the most important parameter to look at when assessing the price
of a warrant.
Volatility is a measure of the frequency and intensity of price change of the underlying asset (a stock or an index) on which a warrant is based. It is an annualised statistic, which represents a standard deviation price change, in percentage terms, at the end of a period.
For example, if an underlying futures contract is currently trading at 100 and has a volatility of 10%, we can expect the same futures contract to be trading between 90 and 110 c. 68% of the time. We can also assume it will be trading between 80 and 120 c. 95% of the time and between 70 and 130 c. 99.7% of the time.
Two types of volatility
Historical volatility is the annualised standard deviation of the logarithm of price relatives, measured at regular intervals. It is retrospective based on historical data. It calculates the historical variations of the underlying asset price over a certain time. This volatility gives an indication of how the underlying asset behaved in the past.
Implied volatility is the volatility used to price options and warrants. At launch date, to price a warrant, the issuer has to figure out how the underlying will move during the life of the warrant. Historical volatility can merely give an indication. Implied volatility is the market consensus for the expected volatility over the term of the warrant's life and, as a result, is not equal to historical volatility, which is based on data over a past period.
The issue price is deducted from the implied volatility, as shown in the following chart.
When the warrant is listed on the exchange, its trading price depends not only
on the theoretical price but also on the law of supply and demand in the market.
The implied volatility one can see on Bloomberg pages or in the local press is
derived from the trading price. The implied volatility thus varies according to
strong demand when investors are chasing a warrant or selling pressure when
clients take profit.
Generally, implied volatility of listed warrants should trade in line with the
corresponding listed or OTC options in the marketplace. Otherwise, arbitrage
opportunities may arise. Listed warrants are usually trading a few volatility
points higher than corresponding OTC options because of all the inclusive
exchange listing fees and legal costs. Besides, listed warrants are more
suitable for retail investors. Warrants represent a relatively low nominal value
(around USD 20-50,000 nominal amount), whereas OTC options usually represent
large transactions between derivatives houses (around USD 50 million nominal
amount) and are therefore more competitively priced. This price difference can
be compared to the mark-up existing between retail price and wholesale price for
any kind of product.
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