By gaining an understanding of how warrant issuers determine the value of warrants, investors should be in a better position to develop an appropriate trading strategy.
The value of a warrant is influenced by the five market variables outlined in the table below. The arrows indicate which direction the value of call or put warrants will move in response to a change in the corresponding variable in most situations.
| Pricing Variables |
| Variable |
Change in variable |
Change in call
warrant price |
Change in put
warrant price |
| Underlying price |
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| Dividend expectations |
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| Volatility |
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| Interest rate |
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| Time to expiry |
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Underlying price
The underlying price is the key driver of the warrant price. As the underlying price increases, the value of a call warrant should increase. Conversely, the value should fall as the underlying price falls.
The opposite occurs for put warrants. Put warrants should increase in value as the underlying price falls and decrease in value as the underlying price rises.
By successfully predicting the price direction of underlying assets, investors can profit from trading warrants on positive and negative views.
The tables below demonstrate the anticipated movements of a call warrant and a put warrant investment. In estimating the returns an assumption has been made that there will be a 10% increase and a 10% decrease in the underlying price at the end of a 3 month investment period.
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Investor purchases 10,000 XYZ Macquarie Call Warrants for $1.00 each.
XYZ's underlying price is $10.00. |
| Underlying Price in 3 months |
$9.00 |
$10.00 |
$11.00 |
| Number of Warrants |
10,000 |
10,000 |
10,000 |
| Warrant Price in 3 months |
$0.40 |
$0.85 |
$1.50 |
| Purchase Price |
$10,000 |
$10,000 |
$10,000 |
| Sale Proceeds |
$4,000 |
$8,500 |
$15,000 |
| Return on Call Warrant |
(60)% |
(15)% |
50% |
| Return on Underlying Investment |
(10)% |
0% |
10% |
Clearly, when the underlying price increased, the warrant provided a better return than the underlying. While the underlying price increased $1.00 (from $10.00 to $11.00), that is 10%, the call warrant increased $0.50 (from $1.00 to $1.50), providing a 50% return.
Note: When the underlying price remains constant at $10.00, the warrant price falls 15% (from $1.00 to $0.85) during the three month investment period. This is due to time decay.
| Investor purchases 10,000 XYZ Macquarie Put Warrants for $1.00 each. XYZ's underlying price is $10.00. |
| Underlying Price in 3 months |
$9.00 |
$10.00 |
$11.00 |
| Number of Warrants |
10,000 |
10,000 |
10,000 |
| Warrant Price in 3 months |
$1.50 |
$0.85 |
$0.40 |
| Purchase Price |
$10,000 |
$10,000 |
$10,000 |
| Sale Proceeds |
$15,000 |
$8,500 |
$4,000 |
| Return on Put Warrant |
50% |
(15)% |
(60)% |
| Return on Underlying Investment |
(10)% |
0% |
10% |
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When the underlying price decreased $1.00 (from $10.00 to $9.00), the warrant provided a 50% return to the warrant holder while the underlying holder sustained a 10% loss. This illustrates how an investor can profit from underlying price falls by holding put warrants.
By gaining an understanding of how issuers determine the value of warrants, investors should be in a better position to develop an appropriate trading strategy.
Delta
We have demonstrated that the direction of the warrant price is directly related to the direction of the underlying price. Generally, warrants do not move cent for cent with the underlying. The relationship between the movement in the underlying price and the corresponding change in the warrant price is referred to as the delta.
A delta of 1 means that the value of the warrant should change one cent for every one cent change in the underlying share price. A delta of 1 also means the warrant is currently in-the-money and there is a 100% expectation that the warrant will expire in-the-money.
A delta of 0.5 means that there is only a 50% expectation that the warrant will expire in-the-money. Accordingly, it means that the value of the warrant should change by 0.5 cents for every one cent change in the underlying price.
Deltas will change over time as the relationship between the Exercise Price and Underlying Price changes. Both delta and prices of warrants on this site are calculated on a daily basis.
While the delta is a useful measurement for investors wishing to track the daily movement of their warrants, it is also important to understand the principle of effective gearing.
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Effective gearing
One simple measure of gearing is to determine how many warrants can be purchased for the cost of one share. For example, if the share costs $20 and the warrant $2, then the gearing is 10. The effective gearing of a warrant provides a realistic expectation of how much the warrant should outperform or underperform the underlying shares over a short period of time. Effective gearing is calculated by dividing the underlying price by the warrant price and multiplying this by the delta.
| |
Effective Gearing
|
=
|
Underlying Price __
(Warrant Price X Conversion Ratio)
|
X
|
Delta
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So it recognises that whilst you may be able to buy, say, 10 times as many warrants as shares, the warrants may not be moving cent for cent with the shares. For example, if the warrant used in the simple gearing example has a 50% delta, then the effective gearing is only 50% x 10 = 5.
An effective gearing multiple of 5 implies that every $1.00 invested in the warrant could equate to $5.00 invested in the underlying.
Investors should be aware that the effective gearing multiple does change and therefore is only applicable for short periods of time.
Time to expiry
The greater the time to expiry, the greater the time value of the warrant. This is because the warrant has more time to perform or move into-the-money.
The time value of warrants can be expected to gradually decline in value to zero over the life of the warrants. This gradual decline in the time value is effectively part of the daily cost of holding a warrant.
An alternative way of understanding time decay for warrants is to consider it as equivalent to the daily decay of an insurance policy. The policy falls in value each day it approaches its expiry date because the period of insurance is decreasing.
Similarly the opportunity for the warrant to move into-the-money is decreasing and therefore the warrant value will decrease. In our hypothetical examples, time decay is responsible for a 15 percent decrease in the warrant price when there is no change in the share price over the three month investment period. While the intrinsic value has remained unchanged, the time value has decreased to produce an overall decline in the warrant price.
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Dividends
Investors in warrants do not receive the dividends paid on the underlying, nor or do they directly participate in rights or bonus issues.
However, in valuing warrants, issuers estimate the expected dividend stream of the underlying. This means that call warrants should not dramatically fall in price when the underlying trades ex-dividend. Similarly, put warrants should not substantially increase in price. Generally, in the case of a rights or bonus issue, the terms of the warrant are adjusted so that the investor is not disadvantaged.
Volatility
Volatility is a standard measure of risk on the underlying. Issuers will forecast the expected volatility of the underlying price for the life of the warrant. The higher the volatility, the higher the risk on the underlying and therefore the more expensive the warrant will become.
Interest Rates
For each call warrant issued, issuers allocate funds to purchase underlying. If the cost of borrowing (ie. the interest rate) increases, the cost will be reflected in a corresponding increase in the warrant price.
Similarly, a put warrant will decrease in value when interest rates rise.
Warrants derive their value from another financial instrument such as shares, currency, an index or units in a unit trust. While returns from investing in warrants may outperform returns on shares, there are a number of additional factors determining warrant values, hence they are seen as more risky than trading ordinary shares.
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