Tutorial: Warrants

What are warrants?

Warrants are securities that transfer the right (but not the obligation) to the holder to buy or sell an underlying instrument (for example, a share). A call warrant gives you the right to buy the underlying instrument at a later date at for an agreed price (i.e. the strike price). A put warrant is just the opposite – it gives you the right to sell the underlying instrument at a later date for an agreed price (i.e. the strike price). A warrant may be either exercised during the term (American style) or at the end of it (European style). Warrants may be traded on the stock exchange or over the counter.

How do warrants work?

A call warrant gives you the right to buy the underlying instrument at a later date for an agreed price. Of course you will only want to exercise this right if the price of the underlying is higher than the strike price (“in the money”). This way you could buy the underlying instrument from the issuer at the strike price and sell it on at the currently higher price on the stock exchange. If the price of the underlying is at (“at the money”) or below (“out of the money”) the strike price, it does not make sense to exercise the purchase right. In this case you would lose your invested capital.

The picture looks exactly the other way around for a put warrant. Here you get the right to sell the underlying instrument at a later date for an agreed price. You will only want to exercise this right if the price of the underlying is below the strike price (“in the money”). In this case, you can buy the underlying instrument on the stock exchange and sell it to the issuer at the higher strike price.

In practice, instead of the actual delivery of the underlying instrument the transaction tends to be settled in cash by paying the difference between the price of the underlying on the day of exercise and the strike price.

Warrants give the investor the chance to benefit at disproportionately high rates from fluctuations in the price of the underlying. This leverage effect is due to the relatively lower capital investment involved in the purchase of a warrant in comparison with an investment in the underlying instrument.

The price of a warrant is influenced by the following variables during its term:

Price of the underlying instrument

The current price of the underlying and the strike price set the intrinsic value of a warrant. The intrinsic value of a call warrant is the positive difference between the price of the underlying and the strike price. For a put warrant, the intrinsic value is defined as the positive difference between the strike price and the price of the underlying. If the price of the underlying rises/falls, this movement will usually push up the price of the call/put warrant.

Volatility

The volatility of the underlying has a very strong influence on the value of the warrant. Usually an increase in volatility would also trigger an increase in the value of the warrant, and vice versa.

Remaining time to maturity

The longer the remaining time to maturity of the warrant, the better the chances of the underlying instrument moving in the “right” direction for the warrant. With the remaining time to maturity shrinking, the so-called time value decreases as well, and equals zero on the expiry date.

Risk-free market interest rate

The increase of the risk-free interest rate has a positive effect on the value of a call warrant and a negative one on the value of a put warrant.

Your benefits

Warrants allow you to benefit from market movements at disproportionately high rates. There is a vast array of warrants available for rising (calls) and falling (puts) prices. A put warrant is one of the few instruments on the equity market that gives you the chance to benefit from falling markets.

Your advantages

You participate in the price movements of the underlying at disproportionately high rates.
You can participate in rising and falling markets.
You can protect your portfolio against short-term price declines.

Details you should be aware of

You may lose your entire investment
If you decide to exercise the right to buy or sell the underlying, you have to bear in mind the fees and deadlines associated with the transaction.

How do warrants react to…

… rising markets?
If the price of the underlying rises, and all other variables remaining equal, the value of the call/put rises/falls disproportionately.

… stable markets?
If the price of the underlying remains stable, the value of the warrant tends to decrease due to the falling time value.

… falling markets?
f the price of the underlying falls, and all other variables remaining equal, the value of the call/put falls/rises disproportionately.

Payoff-Chart

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