Sunday, 11 March 2012

Warrants trading: What you need to know

Parameters & Variables of Structured Warrants
To figure out the relationship between share price and the associated warrant price, the investor has to break down the premium factor that he/she pays for. 
Premium, Intrinsic & Time Values: The premium measures the extra cost incurred when buying a warrant and “exercising” the warrant into share over direct share purchase. 
Premium = [(Warrant Price + Exercise Price) - Share Price) / Share Price] x 100% 
Example (Diagram 1): if a warrant priced at RM0.50, has an exercise price of RM1.00, while the underlying share price is RM1.20, the premium on the warrant is 25%. 
Premium (%) = [(0.50+1.00)-1.20]/1.20 x 100% = 25% 
Besides premium, there is another dimension of valuing structured warrants, based on intrinsic and time value. 
Warrant Price = Intrinsic Value + Time Value 
The intrinsic value of a warrant is the difference between share and exercise price. In our example, the warrant’s intrinsic value of RM0.20 represents the possibility of buying shares for RM1.00, even though the market share price is RM1.20 (Diagram 2). 
The additional RM0.30 is known as the time value. It reflects the payment for profit opportunity if the underlying share moves in the warrant buyer’s favour. In our example, if the warrant was to expire tomorrow, it would be priced around RM0.20. But if the warrant has 9 months before expiry, there's a high chance of the share price increasing. At a time value of RM0.30, this tells us that investors are willing to pay RM0.30 for the potential future gains before warrant expiry. The downside is that time value will fall closer to zero as the expiry date approaches. This is known as time decay. 
If a warrant is out-of-the-money, by definition the warrant has no intrinsic value. In this case, the time value component accounts wholly for warrant price. 
The price will not be lower than its intrinsic value due to the possibility of a risk-less arbitrage – where one buys the warrants and exercises them into shares, for a lower market share price. If a warrant is deep in-the-money, or expires shortly, the price may trade at a small discount to its intrinsic value. 
Valuing Premium & Time Value: A warrant with a time value of RM0.20 is not necessarily “cheaper” than one at RM0.30. Both premium and time value parameters must be used in comparisons. 
Deep out-of-the-money warrants have high premiums, which get lower when becoming more in-the-money. Premiums are regarded as measures of warrant price. While intrinsic value is directly related to share and fixed exercise price, the unpredictable nature of time value makes analysis difficult. 
Implied Volatility: In determining “fair value” of warrants, the most adopted pricing model is the Black-Scholes one. It takes into account the inter-relationship between share and exercise price, expiry date, risk-free interest rate and volatility. 
Volatility represents absolute price movements, of the underlying share over a time period. Traders need to understand that huge volatility is actually beneficial due to “limited loss, unlimited upside” characteristics of structured warrants. 
There are two volatility types – historical, which calculates past variations of underlying share price, and implied, which represents market expectations of future volatility in underlying share price. 
Examining historical volatility requires care, since short-term can differ from longer term. Besides underlying share direction, investors need to question if current volatility is likely to continue. 
Implied volatility is derived from working backwards the current warrant price through the Black-Scholes equation. A warrant is expensive if implied volatility outweighs historical volatility assuming full market efficiency. In reality, implied volatility takes into account maturity length, nature of warrants, and spot/strike levels. Implied volatility is generally higher for longer-dated warrants and put warrants and at-the-money warrants.

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