1. What is a warrant?
A warrants, i.e., a “subscription warrants”, refers to a right rather than a liability (the investor may choose not to exercise such right under the unfavorable circumstances), and is used to purchase (call warrants) or sell (put warrants) the underlying stocks, which can be stocks, currencies and indexes, at a pre-determined strike price, on the scheduled expiry date.
2. Definitions in relation to warrants
- Strike price
It refers to the price of the underlying stocks bought (call warrants) or sold (put warrants) by the warrants holder at the expiry date.
* The strike price is clearly listed in the listing documents. The strike price will not be adjusted in case that no corporate action is taken for the underlying stocks prior to the expiry date, such as offering shares and distributing incentive shares. When the enterprise distributes incentive shares or offer shares, the strike price of the warrants will be adjusted downward.
According to the different value status of the warrantss, and the gap between the strike price and the ruling price of underlying stocks, the covered warrants is generally divided into three categories, namely, in-the-money, out-of-the-money and at-the-money:
- Call warrants:
Price of underlying stocks > strike price=in-the-money
Price of underlying stocks = strike price=at-the-money
Price of underlying stocks < strike price=out-of-the-money
Put warrants:
Price of underlying stocks > strike price=out-of-the-money
Price of underlying stocks = strike price=at-the-money
Price of underlying stocks < strike price=in-the-money
At the expiry date, the warrants holder will theoretically exercise his/her rights only in the case of in-the-money warrants.
- Expiry Date
The rights of warrants holder can be exercised within a time limit. The expiry date refers to the date on which the warrants holder exercises his/her rights. European-style warrants holder can exercise the conversion rights against the issuer on the expiry date. American-style warrants holder can exercise rights on or before the expiry date. The warrants will, upon the expiration, be de-listed from the stock exchange and automatically settled.
- Time value
The value of the warrants is declining as the stock warrants approaches the expiry date. We call it the loss of time value. The primary cause for the decline of the warrants price over time lies in that the expected value of rights exercised will also gradually decline upon the expiration as the stock warrants approaches the expiry date. The warrants price will also drop if there is no change in the price of the underlying stocks when the investors hold a warrants for a long period of time. The daily time value loss of the warrants will change along with the value of the warrants. The deeper the warrants out-of-the-money , the greater the time value loss.
- Last trading date
It refers to the last day when the warrants may be traded on the exchange. If the investor does not exercise put option of warrants prior to the last trading day, he/she need to wait for the stock warrants settlement. The last trading day of the warrants is the fourth trading days prior to the expiry date.
- Delta
It refers to the number of underlying stock required to be called/put at the time of hedge, when the issuer puts/calls a warrants. The investor can calculate the theoretical rise and fall of the warrants based on the Delta. However, Delta of the warrants will change along with the price of the underlying stock. Therefore, the price of the warrants will rise or fall more or less than the theoretical price. Delta of the call warrants ranges from 0 to 1, and that of put warrants is from -1 to 0. The deeper the warrants out-of-the-money, the closer the Delta will be to 0！！！
The way of calculating the change in theoretical price of the call warrants based on the Delta:
Price change of call warrants = (price increase of underlying stock / entitlement ratio) x Delta = ($1 / 10) x 0.5= $0.05
In case that Delta of the call warrants B is 0.5 (At-the-money, the price of underlying stock= strike price), the call warrants (entitlement ratio = 10) should theoretically rise by $0.5/10=$0.05 when the price of the underlying stock rises by $1; such increase is an absolute value.
* Investors should note that Delta will change with the influence of the underlying stock price and other factors. The effective gearing of the above call warrantss will also change upon the price variation.
Assuming that the Delta becomes 0.52 upon the rise in the price of underlying stock:
Subsequent change of call warrants price = (price increase of underlying stock / entitlement ratio) x Delta = ($1 / 10) x 0.5= $0.052
- Gearing
The gearing shows the multiple proportions of warrants price and the underlying stock price in actual figures, by adopting the computational formula Of:underlying stock price/ (the warrants price x entitlement ratio).
- Effective gearing
It is used to reflect the theoretical variation of the warrants price for every 1% change in the underlying stock price. The reference value of effective gearing is higher than that of the gearing, which is more effective and practical. The following is a formula for calculating effective gearing, mainly by adding the Delta parameter when calculating the gearing:
Effective gearing / actual gearing= Delta x underlying stock price / (warrants price x entitlement ratio)
- Entitlement ratio
It refers to the number of warrantss held by the warrants holder in order to be entitled for one underlying stock. For example, the entitlement ratio of certain Call warrants A of China Mobile is 100:1, that is, for every 100 covered warrantss held by the investor, the investor is entitled to exchange for one underlying stock of China Mobile at the settlement price on the expiry date of stock warrants.
The entitlement ratio of stock warrants is limited to 1, 10 and 100. The entitlement ratio of the index warrants and other underlying stocks only need to be a multiple of 10.
- Outstanding
Outstanding refers to the number of warrantss held by market investors (except the issuer). This value is sometimes expressed as a percentage. When the outstanding of the warrantss exceeds 50%, the issuer can apply for additional stock warrantss, and the additional issuance will be listed after three trading days.
- Premium
Call warrants premium = {[strike price + (call warrants price x entitlement ratio)] - underlying stock price} / underlying stock price x 100 %
Put warrants premium = {[strike price + (put warrants price x entitlement ratio)] - underlying stock price} / underlying stock price x 100 %
- Implied volatility
Implied volatility of the warrants can be calculated backward based on the warrants price and other factors such as the expiry date and strike price via the option pricing model (Black-Scholes Model). The implied volatility can be seen as an expectation towards the future volatility in the market for the underlying stock price, which is also related to the over-the-counter (OTC) options market.
Investors also refer to the historical volatility to measure whether the level of implied volatility of the warrants is reasonable. Standard Deviation of this data is obtained statistically based on the ups and downs of the underlying stock price over time. However, this volatility data does not reflect the future volatility of the underlying stock and should only be used for reference purposes.
In general, in the case of warrantss subject to similar terms, the lower the implied volatility, The cheaper the issuer's selling price. It is also used as standards for comparison of fair price of warrantss.
- Break Even point
Break Even point means how much the underlying stock price needs to rise/fall if the investor buys and holds the warrants until the expiry date, so that the investor can break even.
Break Even point of call warrants = {[strike price + (call warrants x entitlement ratio)]
Break Even point of put warrants = {[strike price + (put warrants x entitlement ratio)]
3. Factors affecting the warrants price
The warrants price can be easily divided into two parts: the intrinsic value and the time value.
The intrinsic value of the warrants depends mainly on the price gap between the underlying stock price and the strike price of the stock warrants. The in-the-money call warrants or put warrants has an intrinsic value and a time value. On the contrary, the out-of-the-money warrants has only a time value, of which the intrinsic value is equal to 0. In addition, if the actual dividend payout is more than expected, the ex-dividend factor will also affect the intrinsic value of the warrants.
Intrinsic value of call warrants = underlying stock price - strike price
Intrinsic value of put warrants =strike price- underlying stock price
The time value of the warrants is mainly affected by the remaining date of the warrants, the market's implied volatility and interest rate factors.
- The six main factors that affect the intrinsic value and time value of the warrants are listed below:
Call warrants price
Put warrants price
Underlying stock price
warrants strike price
Remaining date
Implied volatility
Actual dividend compared with expected dividend
Rate of interest
*Since the warrants is a listed trading product, its price is also affected by market supply and demand.
Here we focus on four factors that affect the warrants price:
- Underlying stock price
The investors generally pay more attention to the trend of underlying stock price among the various factors affecting the warrants price. The price of call warrants is consistent with the price trend of the underlying stock, while the price of put warrants presents a reverse trend with the underlying stock price. The underlying stock price will rise if other factors remain unchanged and the underlying stock price rises, and the put warrants price will rise as the underlying stock price falls.
- Remaining date
The time value will decrease over time. The closer to the expiry date, the faster the time value will decrease until the time value becomes zero on the expiry date. The longer the remaining dates of the warrants, the greater the time value, so its price will be higher.
On the other hand, when the remaining date is reduced, the loss of the time value will be accelerated and decremented by Linear. If investor buys a short-term warrants, the loss risk of time value is greater. The deeper out-of-the-money warrants, the faster decline of the time value.
- Implied volatility
Implied volatility can also be seen as a market expectation of future volatility, which is related to changes in OTC options market price. The rise and fall of the implied volatility is affected by the expected volatility of the underlying stock, and the supply-demand relationship of OTC options. If the underlying stocks trend and move within a narrow range, pressure will be put on the price of the implied volatility of the relevant stocks.
Implied volatility of the warrants can be calculated backward based on the warrants price and other factors such as the expiry date and strike price via the option pricing model (Black-Scholes Model). Therefore, the implied volatility can be understood as a scale for price and volume of the stock warrants price. When two warrantss are subject to the same terms, the warrants with low price may have lower implied volatility in the context that they have the same other parameters.
- Actual dividends
The holder of the European-style warrants cannot obtain the dividend payout of the underlying stock. The dividend payout of the underlying stock will cause the price to be adjusted downward due to the ex-dividend before the expiry date of the stock, which is unfavorable to the warrants holder. However, the issuer has generally referred to the market's expected dividend payout level and taken into account the dividend payout factor while pricing the warrants. Therefore, if the amount of dividend payout is consistent with market expectations, the dividend payout will not affect the price of stock warrants.
All adjustments arising from the discrepancy between the actual dividends and the issuer's expected dividends (e.g. the distribution of large-value special dividends) will be made in the next trading session after the dividend is announced. Negative impact will be generated on the call warrants price if there are more actual dividends than expected; otherwise, benefits will be produced; the impact on the put warrants price is just the opposite.
In addition, it has been wrong to think that the warrants price is adjusted solely on the ex-dividend date of underlying stock. Otherwise, the investor can obtain the risk-free profit by buying the put warrants before the stock ex-dividend date.
4. Expiration settlement method
Cash value of call warrants= (settlement price – strike price) / entitlement ratio
Cash value of put warrants = (strike price - settlement price) / entitlement ratio
Stock warrants:
The settlement price refers to the average closing price of the underlying assets on the 5 trading days prior to the expiry date of the warrants (the closing price on the expiry date is not included).
Index warrants
The settlement price is based on the EAS (expected average settlement price) published by the Hong Kong Exchanges and Clearing Limited (HKEX). EAS refers to the average price of relevant indexes every 5 minutes on the expiry date of the front-month futures indexes.
The investor often confuses the multiplier concept of the futures contract and times the index settlement value by the futures contract multiplier of 50 when calculating the index settlement price. We should take a multiplier of 1, instead of 50 for the HSI large futures contract, when calculating the settlement value of the index warrants.