Saturday, 12 September 2015

Warrants: Implied Volatility and Warrant Price

Apart from the underlying price, the most important factor that affects the price of a warrant is implied volatility.

It is the expected volatility of the underlying in a given future period of time and is positively related to the warrant price.

When the implied volatility of a warrant increases, its price may go up.

When the implied volatility decreases, the warrant price may go down.

An example:

Stock A is currently trading at $10.  The market expects that the range of fluctuations of the stock will be within $1 for most of the time in the future.

Stock B is currently trading at $10, and the market expects that its range of fluctuations will be within $5 for most of the time in the future.

What is the probability that stock A will climb to $20 within 6 months?

Which one, between Stock A and Stock B, will have a better chance of hitting $20 in 6 months?

Obviously, the answer is Stock B.

If for some reasons, the market expects a drop in the volatility of  stock B (say from $10 to $1 in terms of the range of fluctuations) in a given period of time, then the price of a related warrant may go down as well.

This is due to the lower probability that the price of Stock B will exceed the strike price of the warrant upon maturity.

Hence, there is less chance for the warrant to be exercised upon maturity, and the investor will also have a less chance to get a higher return.  As a result, the warrant price is likely to fall.

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