INTRODUCTION TO WARRANTS This Presentation Should Help You: Understand Why Investors Buy s Learn the Basics about Pricing Feel Comfortable with Terminology Table of Contents Sample Term Sheet Scenario Analysis Why Buy Call s? Pricing Model Risk Measurement Definitions SAMPLE TERM SHEET HSBC Call s Issuer: ABC Investments Co., Ltd Underlying Shares: HSBC (Ticker: 00005.HK) Issue Size: 10 million warrants Launch Date: August 8, 2000 Maturity Date: August 8, 2001 Reference Spot Price: HK$105.00 Exercise Price: HK$105.00 (100% of the Reference Spot Price) Price: HK$15.92 (15.2% of the Reference Spot Price) Premium / Gearing: 15.2% / 6.6x Option Style: European Settlement Date: August 18, 2000 Listing & Listing Date: Hong Kong Stock Exchange, August 18, 2000
WHY BUY CALL WARRANTS? Leverage Insurance Cash Extraction Volatility Trading Leverage Higher Percentage Gain on the Upside, but Higher Percentage Loss on the Downside also
Leverage Insurance Cash Extraction Volatility Trading Insurance Call Costs Less than that of the Underlying Stock for the Same Notional Exposure Even if the Stock Crash the Buyer Can Lose at Most the Initial Premium Paid Leverage Insurance Cash Extraction Volatility Trading Cash Extraction Raise Cash While Maintaining the Same Underlying Notional Exposure by Selling Shares and Purchasing the Same Number of s Leverage Insurance Cash Extraction Volatility Trading Volatility Trading Benefits from Potential Increase in Stock Price Fluctuations Stock Price Price Increases When Underlying Share Price Becomes More Volatile
WARRANT PRICING MODEL Type Stock Price Strike Price Volatility Dividends Maturity Interest Call Option: Right (Not the Obligation) to Buy the Underlying Asset at a Predetermined Price on or Before a Specified Date
Asset Price Profit Strike Time Put Option: Right (Not the Obligation) to Sell the Underlying Asset at a Predetermined Price on or Before a Specified Date Asset Price Strike Profit Time WARRANT PRICING MODEL Type Stock Price Strike Price Volatility Dividends Maturity Interest American Style: A that Can be Exercised Anytime During Its Life European Style: A that Can be Exercised ONLY at Maturity
Type Stock Price Strike Price Volatility Dividends Maturity Interest Stock Price Goes Up => Call Price Goes Up Type Stock Price Strike Price Volatility Dividends Maturity Interest Higher Strike Price => Lower Call Price Call Put At-The-Money: Stock Price = Strike Price Stock Price = Strike Price In-The-Money: Stock Price > Strike Price Stock Price < Strike Price Out-of-The-Money: Stock Price < Strike Price Stock Price > Strike Price Type Stock Price Strike Price Volatility Dividends Maturity Interest Measure of Stock Price Fluctuations Higher Volatility Increases the Chance that the Will End Up Further In-the-Money or Out-of-the Money Higher Volatility => Higher Call Lower Volatility Higher Volatility
Type Stock Price Strike Price Volatility Dividends Maturity Interest Cash Dividend Reduces the Stock Price on the Ex-Dividend Date Higher Cash Dividend => Lower Call Price Type Stock Price Strike Price Volatility Dividends Maturity Interest Longer Maturity Gives the Holder a Longer Period to Decide Whether to Exercise the Option Longer Maturity => Higher Call Price Type Stock Price Strike Price Volatility Dividends Maturity Interest Since Call is a Leveraged Instrument, Higher Interest Increase the Financing Costs and the Buyer Must Pay More for the Call Higher Interest = > Higher Call
WARRANT PRICING MODEL Summary: Effects of Changes in Parameters on Pricing Call Put Underlying Stock Strike Price Volatility of the Underlying Stock Cash Dividend Maturity Interest RISK MEASUREMENT Delta Gamma Theta Vega Rho Delta = Price / Stock Price The Change in Option Price Given a $1 Move in Stock Price It is also the Number of Shares a Issuer Needs to Buy Per Call (the Hedge Ratio ) to Neutralize the Directional Risk of the Underlying Stock Delta Gamma Theta Vega Rho Gamma = Delta / Stock Price Change in Delta Given a $1 Move in the Stock Price In Real Life Terms, One Can Think of Delta as the Velocity and Gamma as the Acceleration of a Speeding Car A Higher Gamma thus Implies a Correspondingly Higher Risk / Reward Delta Gamma Theta Vega Rho
Theta = Price / Time Also Known as Time Decay Measures the Reduction in Option Price Each Day Delta Gamma Theta Vega Rho Kappa or Vega = Price / Volatility Change in Price Given a 1% Change in Volatility Delta Gamma Theta Vega Rho Rho = Price / Interest Rate Change in Price Given a 1% Change in Interest Affects Long-Dated Options (Longer Than 1 Year) Significantly More Than Short-Dated Options
WARRANT DEFINITIONS Premium Gearing Leverage Intrinsic Time Premium = Call Price (Stock Price Exercise Price) Stock Price The Break-Even Level at Maturity in Order for the Buyer to Recover the Original Cost of the Option. Example: a 5% Premium Means the Stock Price will Need to Increase by 5% at Expiration for the Buyer to Break-Even on His Original Investment Premium Gearing Leverage Intrinsic Time Gearing = Stock Price / Price The Dollar of the Stock Controlled by One Dollar Worth of Gearing is Not the Same as Leverage Premium Gearing Leverage Intrinsic Time Leverage = Gearing X Delta The Percentage Change in Price Given a 1% Move in Stock Price Example: 3 Times Leverage Means the Price Will Go up Roughly 3% for a 1% Increase in the Underlying
Premium Gearing Leverage Intrinsic Time Intrinsic Measures the In-the-Moneyness of the Call Intrinsic = Max (0, Stock Price Strike Price) Put Intrinsic = Max (0, Strike Price Stock Price) Price = Intrinsic + Time Premium Gearing Leverage Intrinsic Time Time = Price Intrinsic of the Right to Exercise the in the Future Rarely Less Than Zero Before Expiration Since the Right to Exercise is Worth Something In Most Cases, a Holder is Better Off Selling Rather than Exercising the Early, Even if it is In-the- Money Premium Gearing Leverage Intrinsic Time Covered : A Issued by a Third-Party Issuer, Such as a Merchant
Bank. Such a Does Not Change the Capital Structure of the on Which the is Issued. : A Issued by the Underlying Itself, Usually as Part of a Fund Raising Exercise. Such a Enlarges the Capital Base of the. Premium Gearing Leverage Intrinsic Time Number of s That Has to Be Exercised in Order to Receive One Share of Stock Example: A of Ten Means That Holders Have to Exercise Ten s to Receive One Share of the Underlying Stock SUMMARY Investors Buy s for 4 Main Reasons: Leverage, Insurance, Cash Extraction, Volatility Trading Pricing Model Requires 7 Basic Inputs: Type, Stock Price, Strike Price, Volatility, Maturity, Interest, Cash Dividends A s Risks Can Be Measured by the 5 Greeks Delta, Gamma, Theta, Kappa or Vega, Rho 7 Commonly Used Terms in the Market Premium, Gearing, Leverage, Intrinsic, Time, s, and