SUPPLIER AND TECHNOFIN®

Covered Warrants: focus on vitality

One of the key determinants of a warrant’s price is the implied volatility of the underlying asset. All else being equal, the price (specifically the time value) of a warrant will increase as the volatility of the underlying asset rises.

As a result, purchasers of warrants need to be aware that they have a long exposure to volatility – irrespective of whether they have purchased a call or a put.

With that in mind, this section aims to shed some light on what we mean by the term ‘volatility’, touch on how such a figure is calculated, differentiate between the ‘implied’ and ‘historical’ versions of the number and importantly explain how investors can use volatility to understand whether a warrant is cheap or expensive on a relative basis.

Volatility is a measure of the intensity of price movements rather than their direction. If the underlying asset has a high implied volatility then there is increased uncertainty as to its future price.

This uncertainty leads to greater potential risk to the writer of the warrant (and obviously greater opportunities for the purchaser) resulting in them charging a greater premium (i.e. a higher price).

Conversely, if the underlying asset has a lower volatility the risk to the writer is commensurately lower and so the premium charged falls.

Let’s take a couple of UK stocks to illustrate the point

Marks & Spencer Group plc might currently be described as a lower volatility stock. When you look at the distribution of its historical returns (the daily swings in its share price), they are tightly bunched By contrast a stock such as ARM Holdings generated significantly higher and lower returns respectively in the same period and its distribution looks more widely spread, indicative of a higher volatility

So how do these historical returns translate into the implied volatility that is used in the pricing of a warrant?

Firstly, we need to differentiate between the two different forms of volatility – historic and implied. Historical volatility, as we showed in the above examples, is a measure of the intensity of price fluctuations of a given underlying asset over a certain period in the past.

It is expressed as an annualised standard deviation of historical returns and is an objective number. Implied volatility on the other hand is an estimate of an underlying asset’s volatility for a particular period in the future.

The historical volatility measurement is a useful data point as it is a key reference point for the estimation of implied volatilities.

Using the past to estimate the future is not an exact science, and there will be differences between historic and implied volatilities – but nonetheless it is a benchmark for pricing.

What is volatility and how does it affect a warrant’s price?

The second pricing benchmark is the exchange traded option market where the current volatility of an option with similar terms (e.g. strike, underlying, maturity date etc.) can be used as a source for warrant implied volatilities as it reflects the option market’s best view of future volatilities.

 Combined, these two reference points are used in the formation of the implied volatilities used in warrant pricing. So how should investors use the implied volatility in their selection of a warrant?

Implied volatility is, by its very nature, a best estimate, and therefore it is the one input into the warrant pricing calculator that is subjective.

The other factors such as the price of the underlying, the strike, the time to expiry and so on are known, and this makes the implied volatility figure a very useful tool with which to compare warrant valuations.

Let’s say you were bearish on the Nasdaq 100 index. One way to select the cheapest put warrant from the range you have selected would be to sort by implied volatility.

You will find that warrants with the same terms but from different issuing banks will often have slightly different prices.

This variance is driven by the fact that each issuing bank will have their view on implied volatility. Thus, by comparing warrants by their volatility you will be able to find the cheapest warrant to meet your investment need.

Finally, irrespective of the mathematics involved, the volatility that is being used in the pricing of any warrant should be transparent to you at all times. The current implied volatility that is being used – be sure to check it before trading.

Goldman Sachs Europe
Peterborough Court
133 Fleet Street
London EC4A 2BB
Telephone: 0845 609 1555
Fax: 020 8552 8414
E-mail: ukwarrants@gs.com
Web: http://www.gs-warrants.co.uk

Entry Filed under: SUPPLIER AND TECHNOFIN®, Covered Warrants