An example:
Showing posts with label implied volatility. Show all posts
Showing posts with label implied volatility. Show all posts
Tuesday, 15 September 2015
Saturday, 12 September 2015
Warrants: Historical Volatility
Historical volatility reflects the historical price of a stock within a given period of time.
If Stock A is trading at $10 with a volatility of 10%, then based on the theories of statistics, there is
- 68% of the time that the stock will be trading within the range of $9 to $11 ($10 +/- 1 S.D.),
- 95% of the time within the range of $8 to $12 ($10 +/- 2 S.D.)and
- 99.7% of the time within the range of $7 to $13 ($10 +/- 3 S.D.).
In other words, the higher the historical volatility of the underlying, the higher the level of its future volatility will be in a given period of time.
For the investors
Investors can use historical volatility to predict the future volatility and price direction in order to formulate their investment strategies.
For the issuer
For the issuer, historical volatility is one of the factors they need to take into account in determining the price of a warrant.
Where the historical volatility of its underlying is high, a warrant is likely to be issued at a higher price. However, past performance may not indicate future trends.
Hence, in the pricing process, an issuer will alos find out what the markte expects of the future volatility of the underlying, that is what we call the "implied volatility" of the warrant.
If Stock A is trading at $10 with a volatility of 10%, then based on the theories of statistics, there is
- 68% of the time that the stock will be trading within the range of $9 to $11 ($10 +/- 1 S.D.),
- 95% of the time within the range of $8 to $12 ($10 +/- 2 S.D.)and
- 99.7% of the time within the range of $7 to $13 ($10 +/- 3 S.D.).
In other words, the higher the historical volatility of the underlying, the higher the level of its future volatility will be in a given period of time.
For the investors
Investors can use historical volatility to predict the future volatility and price direction in order to formulate their investment strategies.
For the issuer
For the issuer, historical volatility is one of the factors they need to take into account in determining the price of a warrant.
Where the historical volatility of its underlying is high, a warrant is likely to be issued at a higher price. However, past performance may not indicate future trends.
Hence, in the pricing process, an issuer will alos find out what the markte expects of the future volatility of the underlying, that is what we call the "implied volatility" of the warrant.
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.
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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