Warrants Contents Introduction 1 What is a warrant? 2 Call warrants Put warrants Strike price Underlying asset Expiry date Exercise of warrants Cover ratio Beneﬁts of a warrant 3 Leverage Increased exposure No margin calls Ease of trade Lower transaction costs Pricing of warrants 4 Underlying share price Time to expiry Dividends Volatility Interest rates Summary of parameters Trading strategies 5 Leveraged trading Delta Limited risk trading Out of the money warrants In the money warrants Gearing Effective gearing Time horizon Time decay Underlying asset Basket warrants 7 Call warrants Put warrants Hedging with basket warrants Trading basket warrants Glossary 8 Disclaimer 9 page 2 Introduction Investec is an international, specialist banking group that provides a diverse range of ﬁnancial products and services to a select client base. Since inception, Investec has expanded through organic growth and strategic acquisitions and now has an efﬁcient integrated international business platform, offering all the group’s core activities in South Africa and the UK and select activities in Australia. Investec is organised as a network comprising ﬁve business divisions: Private Client Activities, Capital Markets, Investment Banking, Asset Management and Property Activities. In July 2002, Investec implemented a Dual Listed Companies structure with linked companies listed in London and Johannesburg. A year later, it concluded a signiﬁcant empowerment transaction, where the group’s empowerment partners collectively acquired a 25.1% stake in the issued share capital of Investec Limited. “Capital Markets, Equity Derivatives (“Equity Derivatives”)” is responsible for product issuance, market making, arbitrage and principal trading in equities and equity derivatives. Equity Derivatives has ofﬁces in Australia, Ireland, Mauritius, South Africa and the UK. Clients of Equity Derivatives have access to a wide range of derivative products in the developed and emerging markets. This includes the issuance of securitised derivatives and covered warrants. The team also originates and structures equity based solutions that are tailored to meet clients’ objectives. What is a warrant? In their simplest form, warrants are options that are sold as securities and traded on a registered stock exchange. Warrants are tradable rights to buy and sell shares. Through the leverage effect, warrants are able to amplify the price movements in underlying shares. While warrants are speculative instruments, they should be viewed as tools to allow investors to modify their risk proﬁles through the leverage gained. There are two basic types of warrants: call and put warrants. Call warrants Call warrants give the buyer (holder) the right, but not the obligation, to buy the underlying asset (share) at a ﬁxed price (strike price) on a future date (expiry date). These warrants allow investors to proﬁt from share price rises, as the price of a call option will increase exponentially with the corresponding rise in the underlying asset and fall if the underlying asset falls, all other things being equal. For the holder of a call option, the potential loss is limited to the amount of premium paid. Buying a call warrant Payoff Share price page 3 Put warrants Put warrants give the buyer (holder) the right, but not the obligation, to sell the underlying asset (share) at a ﬁxed price (strike price) on a future date (expiry date). Through put warrants, investors can proﬁt from share price falls, as the price of a put option will increase with the corresponding fall in the underlying asset and fall if the underlying asset rises, all other things being equal. For the holder of a put option, the potential loss is limited to the amount of premium paid. Buying a put warrant Payoff Share price Strike price (or exercise price) The strike price is the pre-determined price at which the underlying asset can be bought (calls) or sold (puts) if the warrant is exercised. Underlying asset While shares are the most common underlying assets in the covered warrant issues, indices, baskets of shares, bonds, commodities and currencies can also be used as the underlying asset. For simplicity we shall refer to the underlying asset as shares. Expiry date The expiry date of a warrant refers to the last date on which a warrant can be exercised. American style warrants can also be exercised on any day up to and including the expiry date. European style warrants can only be exercised on the last date or expiry date (this does not, however, exclude investors from trading the warrants during their issuance). Exercise of warrants Exercise of a call warrant implies buying the underlying share at the strike price. In the case of a put warrant, the underlying share would be sold and the investor would deliver these shares to the issuer. Warrants can also be cash settled. In this case, the holder is paid an amount (if any) by which the price of the underlying is more than (call) or less than (put) the exercise price. The exercise of a warrant will only be proﬁtable to an investor if the share price is above the strike price for a call warrant or below the strike price for a put warrant. Cover ratio Many warrants have a cover ratio, which relate to the number of warrants necessary to exercise one share. For a warrant that has a cover ratio of ﬁve, ﬁve warrants are needed to exercise one share. page 4 Beneﬁts of a warrant Leverage Investec warrants are a leveraged share investment. This means that the price changes of a warrant, in percentage terms, are much greater than the price changes in the underlying share. Unlike futures or margined trades, however, the maximum loss for the investor is limited to the warrant price paid. 180% 160% 140% 120% 100% 80% 60% 40% Period 01 02 03 04 01 02 03 04 Underlying Call Warrant Fig 1 This chart illustrates that for movements in the share price, the call warrant price will show geater price movement as a percentage of capital invested. Increased exposure As warrants cost only a fraction of the underlying share price, investors can increase their exposure to the underlying share while committing signiﬁcantly less capital to the trade. By using this increased exposure, investors can realise the same returns as the underlying share and the additional capital can be used for further investment. No margin calls Investors are not obliged to commit additional capital once a warrant has been purchased. The warrant may be sold, exercised or allowed to lapse. The maximum potential loss is limited to the amount paid for the warrant, including transaction costs, while the upside potential is unlimited in the case of calls and only limited to the amount that the share can fall in the case of puts. Ease of trade Investec warrants are listed on various stock exchanges and can be traded by all registered brokers with access to that speciﬁc exchange. Investec will ensure an active secondary market in the warrants, providing bids and offers during market hours. Lower transaction costs Warrants allow leveraged exposure to the underlying share for a signiﬁcantly lower price than purchasing the actual asset. This translates into lower transaction costs since they are usually based on the size of the investment. Pricing of warrants Underlying share price The most inﬂuential variable affecting the price of a warrant is the underlying share price. The value of a call warrant will increase with an increase in the underlying share price and will correspondingly decrease with a fall in the underlying share price. Conversely, put warrants will increase in value with a fall in the underlying share price and fall with a rise in the underlying share price. page 5 Time to expiry The longer the warrant has until the expiry date, the greater its value. The reason for this is that there is a longer period in which the underlying share price has to move “into the money”. A short dated warrant will therefore be cheaper than a longer dated warrant, all other variables being equal. Dividends As warrant holders do not receive dividends, higher than anticipated dividends adversely affect call warrants. They do, however, beneﬁt the holders of put warrants. Volatility Volatility is a measure of the risk inherent in the underlying share. Volatility measures the risk of movement of the share - the higher the volatility of an underlying share, the higher the price of the warrant. This is because a share with a higher volatility will have greater risk and is therefore more likely to move sharply towards or away from its strike price than a share with lower volatility. Interest rates Higher interest rates affect the price of call warrants positively, as the use of warrants allows the investor to gain exposure to an asset for less capital commitment, thus freeing up cash that could be held in a call account and earn interest. Summary of parameters The table summarises the effect of an increase in the various parameters determining the price of a warrant on the level of the premium for calls and puts. Factor Movement Call price Put price Price of underlying share Life span of warrant Volatility Strike price Interest rates Dividend rate Warrant price warrant premium TV = Time value IV = Intrinsic value TV IV out of the money at the money in the money underlying price Fig 4 Call warrants page 6 Trading strategies Leveraged strategies The leveraged method of trading warrants is the most common method used for short-term trading, in the expectation of making a proﬁt from a move in the underlying share. Consider the example below: Share price R20.00 Call warrant price R4.00 Share increase R2.00 or 10% Warrant increase R1.00 or 25% (50c increase for every R1.00 in share) The objective is to increase the proﬁt through the use of leverage. In the example, a proﬁt of 10% can be increased to 25% by the use of a warrant. Delta The price of a warrant is highly correlated to its underlying asset. The measure of this correlation is called the delta. In effect, the delta measures the change in the price of a warrant when the underlying share price changes. A warrant with a delta of 0.5 (or 50%) will move 50c for every R1.00 move in the underlying share. A warrant with a higher delta will therefore have a greater move than one with a lower delta; this becomes useful in comparing different warrants over the same share. It is important to note that as the underlying share price moves, so does the delta. The delta of a warrant can move between zero and one (0% to 100%). For calls, deltas vary between 0 and 1 Strike price 1,0 0,8 0,6 0,4 0,2 0,0 out of the money at the money in the money Fig 2 Delta of a call warrant Limited risk Through the limited risk method, the investor gains the same percentage gain as the share. The exposure to the market (capital committed), however, is signiﬁcantly less. Consider the example below: Share price R20.00 Warrant price R4.00 Warrant delta 0.5 Share increase R2.00 Warrant increase R1.00 Share outlay R20.00 per share Warrant outlay R8.00 (2x R4.00) Here the objective is to capture the same proﬁt as the share - in this case R2.00. By purchasing two warrants instead of one share, the total outlay is R8.00, thus lowering the cash exposure to the market. page 7 Out of the money warrants The further “out of the money”, the cheaper the warrant is likely to be. As the warrant is less expensive, it is likely to have greater leverage than “at or in the money” warrants. If the expectation is for the underlying share price to move sharply higher, then the call warrant that is furthest “out of the money” will produce the highest return. In the money warrants A warrant that is “in the money” is more likely to track the underlying share price. These warrants are useful for the investor who wishes to replicate the underlying share’s performance while committing signiﬁcantly less capital. The gearing of “in the money” warrants is signiﬁcantly lower than that of “out of the money” warrants due to the lower risk associated with high delta options. Gearing Gearing is a measure of how many warrants can be bought for the same amount needed to buy the underlying share. Therefore if the underlying share is R50 and the warrant costs R5.00, the warrant is said to have a gearing of 10. Effective gearing Effective gearing implies that though you may be able to buy 10 times as many warrants as shares, these warrants will not necessarily move in line with the shares. Multiplying the gearing of this warrant by its delta gives us the effective gearing. Equity Derivatives provides daily information relating to the effective gearing and deltas of all their warrants. Time horizon Investors need a clear idea of what the expected amplitude of the movement of the underlying will be and over what time horizon this movement is expected to occur. These two factors are the most important in determining their choice of warrant. A warrant loses roughly two-thirds of its time value over the last third of its life 100% 80% 60% 40% 20% 0% lifespace of the warrant Fig 3 Time decay of a call warrant Time decay Warrants are a wasting asset. This means that the time component of the value of a warrant will decrease as the warrant approaches its expiry date (provided the underlying share and other variables remain constant). Investors should note that time decay increases as the warrant reaches expiry. The shorter the time to expiry, the less likely an out of the money warrant is to move into the money. Underlying asset The ability to make money on warrants will always depend on the behaviour of the underlying shares. Potential investors should seek advice from their stockbroker or ﬁnancial advisor as to the expected performance of the underlying share. page 8 Basket warrants A basket warrant uses a weighted average of the prices of a group of shares as the underlying. This provides an easy way of measuring the performance of this group of shares, as many investors would like to take a view on the value of a particular sector (for example, the ﬁnancial stocks or a basket of the largest capitalised stocks). Investors can also use them to hedge a portfolio. Basket warrants will allow the investor to trade the basket directly through a stockbroker. Unlike trading futures, there are no margin calls for basket warrants. As the premium is paid upfront for the warrant, you can never lose more than the premium paid. Call warrants Basket call warrants allow investors to proﬁt if the level of the basket rises. These warrants are cash settled against the closing level of the basket on expiry. This means that, on exercise, the holder will receive cash for the amount, if any, by which the basket price exceeds the exercise price. If the basket is below the exercise price on exercise, there will be no cash settlement amount. Put warrants Basket put warrants allow investors to proﬁt if the level of the basket falls. On exercise, the holder of a basket put warrant will receive cash for the amount by which the basket is below the exercise price. If the basket is above the exercise price, there will be no cash settlement amount. Hedging with basket warrants Put warrants may be used to protect the value of a portfolio against an anticipated fall in value. Call warrants may be used to protect against an increase in the market, while waiting for funds to become available or while making stock selections. Trading basket warrants Investors may buy and sell basket warrants to capitalise on movements in the underlying basket. Basket call warrants can be used to take advantage of possible increases, while basket put warrants can be used for anticipated market falls. Contact details Investec Capital Markets, Equity Derivative Sales Richard Swain Telephone (011) 286 4742 Email firstname.lastname@example.org Web www.investecwarrants.com For further information log on to www.investecwarrants.com A full product range of all Investec warrants is available on the above website, along with up to date daily matrices, which indicate warrant prices for all movements in the price of underlying shares. If you are interested in trading warrants or would like to know more about them, contact your independent ﬁnancial adviser or broker. page 9 Glossary American style warrants Warrants that can be exercised at any time, up to and including the expiry date. “In the money” warrants When the share price of the underlying asset is above the strike price of the warrant in the case of call warrants or below in the case of puts. In this case the warrants will have intrinsic value. “Out of the money” warrants When the share price of the underlying asset is below the strike price of the warrant in the case of call warrants or above in the case of puts. These warrants will not have any intrinsic value and the price will consist only of time value. Cover ratio The number of warrants that must be exercised into one share or underlying asset. Call warrant A warrant giving the investor the right, but not the obligation, to buy the underlying share at the strike price, on expiry. Delta The delta of a warrant represents the relative change in the price of a warrant to the change in price of the underlying asset. Effective gearing Effective gearing measures the percentage price variation of a warrant for a 1% movement in the underlying asset. Effective gearing = gearing x delta. European style warrants These warrants can only be exercised on the expiry date. Note: they can still be traded (bought and sold) up to and including this date. Expiry date (exercise date) The last date on which a warrant may be exercised. Gearing A measure of how many warrants can be bought for the price of the underlying asset. Gearing = underlying price / warrant price. Intrinsic value The amount by which a share price exceeds the strike price in the case of calls or the amount by which the strike price exceeds the share price in the case of puts. Put warrant A warrant giving the investor the right, but not the obligation, to sell the underlying share at a pre-determined price. Strike price The pre-determined price at which the underlying asset can be bought (calls) or sold (puts). Time value The additional value of a warrant over its intrinsic value due to the remaining term of the warrant. Volatility A measure of the variation of a price over time, expressed in percentage terms. Warrant A securitised option issued by an institution or bank that is traded on a securities exchange. page 10 Confidentiality This communication is conﬁdential and may not be disclosed to any third party without the written consent of Investec Bank Limited. Disclaimer Prospective purchasers of Investec warrants should ensure that they fully understand the nature of warrants and the extent of their exposure. Warrants are not suitable investments for all investors. Investec warrants are primarily exposed to the changes in the underlying share price. In addition, the warrants are exposed to changes in the expected volatility of the underlying share price, interest rates, the time to expiry as well as the expected dividends of the underlying share. Investec warrants are a leveraged investment. Like other leveraged share investments, they provide greater exposure to both increases and decreases in the underlying share price than a direct investment in the underlying share. Potential investors should be aware that they may sustain a total loss of the purchase price of the warrants (Including transaction costs). Warrants represent general unsecured, unsubordinated, contractual obligations of the issuer and rank pari passu in all respects with each other. Purchasers are reminded that the warrants constitute obligations of the issuer only and of no other person. Potential purchasers should understand that they are relying solely on the creditworthiness of the issuer. Potential investors should be aware that they may sustain a total loss of the purchase price of the warrants (including any transaction charges). Clients should be fully aware of the risks involved in trading derivative products. The price and value of investments can fall as well as rise. Past performance of investments may not be a reliable guide to future performance. A ﬁnancial advisor should be consulted prior to entering into any investment. Investec and its afﬁliates assume no responsibility or liability for any consequences arising from the trading of derivative products. Clients should be fully aware of the risks involved in trading stock market related products. Investec Bank Limited does not make representation that the information provided is appropriate for use in all jurisdictions or by all investors or other potential clients. Parties are therefore responsible for compliance with applicable local laws and regulations. All illustrations, forecasts or hypothetical data are for illustrative purposes only and are not guaranteed. This material is for your private information and we are not soliciting any action based upon it. Any terms contained are indicative only. Final terms and conditions are subject to further negotiation. The information contained in this communication does not constitute an offer, advertisement or solicitation for investment, ﬁnancial or banking services. It is for informative purposes and not intended to constitute advice in any form, including but not limited to investment, accounting, tax, legal or regulatory advice. The information therefore has no regard to the speciﬁc investment objectives, ﬁnancial situation or particular needs of any speciﬁc recipient. The material is based upon information that we consider to be reliable, but we do not represent that it is accurate or complete, and it should not be relied upon as such. Investec Bank Limited accepts no liability whatsoever for any loss or damage of any kind arising out of the use of all or any part of this communication. Capital Markets, a division of Investec Bank Limited. Reg. No. 1969/004763/06. An Authorised Financial Services Provider and registered Credit Provider. A member of the Investec Group.