Warrants are structured financial products. They are issued by banks or securities trading houses and relate to an underlying asset. Underlyings can be indices or individual stocks. Currencies, interest rates and commodities are also common underlyings.
Warrants are suitable for implementing certain trading strategies and are primarily used by risk-averse investors and for short-term speculation. Investors often buy and sell the securities again after just a few days or weeks.
Warrants react disproportionately to price movements of a fixed underlying asset, which makes them so attractive: even with a small amount of capital invested, they can achieve high percentage gains in a short period of time. However, this leverage effect also has the opposite effect: If you are wrong in your market expectations and the underlying asset is developing in the opposite direction to what you expected, you will also lose a disproportionately large amount up to the total loss of the invested capital.
The performance of the underlying determines the price of your warrant.
The price of warrants is primarily influenced by the price movements of the underlying asset. However, there are other factors as well, in particular the volatility of the underlying instrument.
Call and put warrants
In addition, there are two opposing basic types for the expectation of rising or falling prices of the underlying asset. Call warrants generally increase in value as the price of the underlying asset rises, while put warrants benefit from falling prices of the underlying asset.
Call warrants: Gains in value with rising prices
A call warrant represents the right to buy a certain underlying asset at a fixed price in a certain quantity. As mentioned above, the underlying asset is a certain stock, a stock index, a currency or a commodity.
If, for example, you think that the stock of a certain company will increase in value in the near future, you can secure the right to this stock by using a call warrant. However, you only need a fraction of the value of the share. How large this fraction is is expressed with the subscription ratio. One to ten, for example, means: A warrant refers to one tenth of the share.
Example of a call warrant:
Underlying: Siemens AG
Share price: 75 Euro
Base price: 70 Euro
Subscription ratio: 0.1
Duration: 2 years
Warrant price: 1.30 Euro
With the above example, you could purchase a Siemens AG share at any time during the next two years with ten warrants at a price of 70 euros (strike price), regardless of where the current share price is. The higher the share price, the more valuable this right is. If the share price rose to 80 euros, the warrant would be worth 1.62 euros. The warrant would thus rise by almost 25 percent, while the share only increases by just under 7 percent. You can simulate such scenarios yourself with the help of the warrant calculator of the Frankfurt Stock Exchange.
European and American option types
A put warrant represents the right to sell a certain underlying asset at a fixed price in a certain quantity. This right gains value when the price of the underlying asset falls. As the holder of a put warrant, you therefore benefit from falling prices.
Put on warrants
Volatility, interest rates and dividends also influence the value of warrants It is not only changes in the underlying price that influence the price of a warrant. The volatility of the underlying asset, is also of great importance.
Historical and implied volatility
A distinction is made between historical and implied volatility. Historical volatility indicates how much the price of a financial instrument has fluctuated in the past. Implied volatility, on the other hand, indicates the degree of fluctuation expected from a particular financial instrument in the future. If the implied volatility for an underlying increases, this leads to rising warrant prices. Why is this so?
Warrants have an asymmetric risk-reward profile. Put simply: the maximum possible loss for you as the buyer is always limited to the capital invested, regardless of the fluctuations of the underlying asset. You can never lose more than you paid to buy the warrants. However, the chances of winning with a warrant increase if the underlying asset fluctuates more strongly and the price fluctuations increase. Therefore, rising implied volatility leads to rising warrant prices.
The explanation for this lies in the futures market. The bank that hedges the warrants issued has to pay higher premiums for the hedging because the risks increase with stronger fluctuations.
However, this also applies vice versa: falling implied volatility leads to falling warrant prices and thus occasionally to unpleasant surprises for investors who are unfamiliar with the influence of volatility.
Interest rates and dividends
Due to their leverage effect, the issuers of the warrants require considerably more capital for hedging purposes than you do to purchase the warrants. The issuers charge interest costs for this capital, which they include in the prices of the warrants.
In the case of call warrants, rising interest rates therefore lead to rising prices. In the case of puts, it is the other way round. Here, the issuers hold the capital whose earnings rise with rising interest rates. The influence of changes in interest rates is usually so small that you will hardly notice it as an investor.
If the issuer holds shares as a hedging position, it naturally also receives the corresponding dividend distributions. This additional income reduces the price of call warrants and increases the price of puts. If the dividend expectation changes, this has an influence on the prices of the warrants. Unexpected special dividends announced by a company can lead to a drop in the price of call warrants on the share in question.
Maturity development of a warrant
In general, a warrant loses value as the remaining term decreases, and its fair value expires. At the same time, however, its leverage effect also increases. In order to better assess the price behaviour of a warrant, a distinction must be made between warrants quoting "out of the money", "at the money" and "in the money":
Warrants "out of the money":
Warrants are out of the money if the agreed strike price in a call is above the current price of the underlying or below a put. It would then be better to buy or sell the underlying asset on the market. The right guaranteed by the warrant no longer has any value.
The shorter the remaining term, the less likely it is that a warrant will return to the money, i.e. reach an intrinsic value.
Warrants "at the money":
If a warrant is at the money, the agreed strike price corresponds approximately to the current price of the underlying asset. These warrants often have a comparatively high leverage effect and make enormous price jumps in both directions. The uncertainty with such warrants is expressed in a very high fair value component. These securities therefore suffer most from the loss in fair value in the final months of their term.
Warrants "in the money":
Warrants are in the money if the agreed strike price is below the current price of the underlying in the case of a call, or above it in the case of a put. These warrants have a high intrinsic value and the fair value component is comparatively low. The fair value loss is therefore rather moderate. The leverage effect is lower than with warrants "at the money".
Risks of warrants
As mentioned above, warrants carry some risks. Especially newcomers to the stock market should always bear these risks in mind. Therefore, here is a brief summary of the most important points:
The term of a warrant is limited. The rights that you acquire with a warrant can lose value during the term or expire at the end of the term. The shorter the remaining term of a warrant, the greater the risk of a loss in value, since the time value falls when the maturity date approaches and the remaining speculative time is short.
Caution with foreign currencies
If the underlying asset is quoted in a currency other than the euro, the investor also bears a currency risk, as the intrinsic value of the product is calculated in the foreign currency.
Almost all structured financial products are legally bonds of the respective issuer. In the event of payment difficulties or insolvency of the issuer, the invested capital is not protected. The investor therefore bears a credit risk.
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