Warrants - An everyday product

Fill it up on Knowledge

In order to explain the origins, background and trading of warrants, we have taken an example from everyday life. The scenario we use involves a driver looking to fill up his car and the owner of a petrol station, who has the flexibility to set prices. This example outlines many of the issues and questions investors looking to trade warrants on a stock exchange would experience. For this reason we have titled this brochure “Fill up on knowledge” and we hope that this everyday example will serve to educate you about warrants and most importantly about the factors that will influence the price of a warrant. The glossary should assist you as you work through this everyday example.

Option contract at a petrol station

Warrants and options both grant the holder of that warrant or option the right, but not the obligation, to buy or sell a financial asset on specific terms and conditions. Where warrants differ from options is that they represent certificated option rights. All warrants have an International Securities Identification Number (“ISIN”) and when issued, are accompanied by a prospectus that specifies their terms and conditions (maturity, exercise ratio etc.). Warrants are normally issued by banks, whereas options are usually made available by and are only traded on futures and options exchanges. Turkish warrants will trade on the Istanbul Stock Exchange (“ISE”)

The example below refers to options rather than warrants, as this correctly describes the contractual arrangement where the option is not certificated nor listed on an exchange. The factors and how these affect the price of the option would however apply in precisely the same way if this was a bank issued and listed instrument - in other words a warrant.

Let us assume that you have just bought your dream car - a top-of-the range powerful sports car. Your initial enthusiasm is short-lived, however, when you pull up at the petrol station to fill-up your new car only to discover that a litre of petrol costs TRY3.5. Even worse you are also aware of recent press reports about rising crude oil prices as well as the petrol tax, and you fear that a litre of petrol may rise to TRY4.5, or perhaps even TRY5.0 within the next two years. Your heart sinks as you realise that your dream car, depending on how fast you drive it, consumes 15-20 litres/100km. You then have a flash of inspiration and enter into the following agreement with the owner of the petrol station. You acquire the right to buy 5 000 litres of premium petrol at TRY3.5 per litre over the next two years. This means you have purchased 5 000 petrol options, each entitling you to buy a litre of petrol under the following agreed conditions. You pay an immediate TRY0.5 per litre for the agreed volume. The right to buy 5 000 litres of premium petrol at TRY3.5 per litre at any time within the next 24 months therefore costs you TRY2,500. You also agree that you may sell your options, in part or in whole, to another car-owner at any time - the owner of the petrol station is not really concerned about whom he sells the 5 000 litres to.

Limited risk – no further obligations

f the price of petrol were to rise to unexpectedly high levels over the two years, you would be in a position to profit by buying 5 000 litres of premium petrol at well below the market price. If the price rose to TRY5.0 per litre for example, you could consider selling your options, which initially cost you TRY2,500, but would then be worth TRY7,500.. This would be a great deal all-round, and what is more, if the price of petrol were to fall, your risk would be limited to the sum needed to purchase the options. If the price per litre dropped to TRY3.0 for example, you would not be obliged to buy the 5 000 litres for TRY3.5. In this instance, the options would expire worthless if the price of a litre of petrol remained below TRY3.5 for the term of the option contract.

Let us now assume that during the agreed period of two years, the price of petrol was to fall dramatically to TRY2.5 per litre. In this instance, you would not make use of your right to buy 5 000 litres of petrol at TRY3.5 and would let the options expire. You would then have to assume the total loss of the sum paid for the options, i.e. TRY2, 500. This loss would have been limited had you sold the options after a few months. If the petrol price were to shoot up to TRY5.0, you would have the following choice. Either you could continue to fill your car with petrol costing TRY3.5 per litre or you could sell your options and make a large profit. Do not forget that as the buyer of the option, you simply have rights, whereas the seller of the option (in this case the owner of the petrol station), has obligations.

Market value of the options

Three months later, during a routine trip to your local petrol station, you notice that a litre of petrol now costs TRY4.5. The value of your options has therefore risen and, contrary to the other drivers you meet at the pumps, you are happy at how things have turned out. Of course, all attention turns to you when they realise that you only have to pay TRY3.5 per litre. You tell them about the deal with the petrol station and a number of motorists then offer to buy some of your options – an informal market materialises. As most people fear that petrol prices are going to increase further, you could sell your options immediately for TRY1.5 per litre. The prevailing market value of each option, which you purchased for TRY0.5, is therefore TRY1.5.

Maturity of the options

The higher the petrol price per litre rises above TRY4.0 – (i.e. above your break–even point) - the more your options are worth and the more profit you will make. Given that you may exercise your options at any time and actually receive delivery of the petrol, and that there are parties interested in buying your options from you, you are free to choose between purchasing the 5 000 litres of petrol over the two years at a fixed cost (currently a significant discount to the prevailing market price) or selling your options. The price the other drivers are willing to pay will, of course, be higher the more expensive a tank of petrol becomes. If the price of petrol were to rise to TRY4.5, you would save TRY1 by exercising your options. However, the "market value", i.e. what others would be prepared to pay for these options, is TRY1.5. There is a good reason for this, namely that three months ago you entered into an agreement with a two-year term, i.e. the options are still valid for another 21 months. During this period of time, the price of petrol could rise to unexpectedly high levels. It therefore follows that the right to buy petrol at TRY3.5 per litre for another 21 months is worth more than the right to do this only for another two days. Another feature of your petrol options is that you and the station owner have agreed to physical delivery. This means that upon exercising the options, you actually receive physical delivery of the underlying, in this instance, the petrol.

Future expectations

Enjoying your role as an option owner, you take a drive one morning and stop to refuel. On the display board at the petrol station you notice that the price of petrol has gone up overnight from TRY4.5 to TRY5.This price rise is due to the Organisation of Petrol Exporting Countries (OPEC) making a surprise decision to reduce crude oil production, thereby sending prices on the crude oil market through the roof and causing oil companies to react as they always do in these circumstances, i.e. by hiking petrol prices. Groups of drivers can be seen standing around the pumps embroiled in heated discussions. An air of panic abounds as everyone fears that petrol prices will continue to rise even higher. Now being well known among local car drivers, you are immediately surrounded by a group of drivers wanting to buy your options for TRY2, even TRY2.5, per litre. A particularly worried driver offers to buy 2 000 options for as much as TRY2.5.per litre. A few days later however the situation is different. Premium petrol has risen to TRY5.5 a litre, yet no one expects prices to rise further. The government has announced that, if necessary, it will lower petrol tax to keep prices stable. When you ask other drivers what they would be willing to pay for your options, the highest bid you receive is TRY2. It therefore goes without saying that expectations of future price trends for the underlying affect the value of an option. Hopefully, at the height of the panic, you accepted the highest bid and sold some of your options, leaving your angst-ridden buyers to curse the planned petrol tax cuts and bemoan their unlucky investment decision.

Trading on the stock exchange

Since acquiring your petrol options, you have developed a keener interest in petrol price trends and their influences. One day, you read an interesting newspaper article about a car maker. The manufacturer is about to bring out an attractive, high-performance car that only consumes 2 litres/100km. The model looks set to be a roaring success - especially given the further rise in petrol prices over the past weeks and you are confident that the share price of the car maker will rise significantly. In view of your positive experience of petrol options, you decide to try your luck with warrants traded on the stock exchange. The problem here is that there are a whole host of warrants available on the said car manufacturer’s shares. All you have to do now is choose the right one. With the car manufacturer's shares currently trading at TRY43,you follow your assessment that they will significantly appreciate in value and therefore opt for a call warrant. However, before you part with your cash, you want to know which warrants are likely to be best for your assessment. This involves looking at various key data on the risk/return profile of these warrants. These indicators can give you an idea of not only how much more expensive a warrant on the shares of the car manufacturer is than buying the shares directly but also how much the price of your warrant can fluctuate over time. These decisive details are outlined in the section "Warrants the basics". Having understood our petrol station scenario, we would now like to introduce you to the world of warrant trading on the stock exchange.