## The basics

**The basics**

It is a well-known fact that investors can make a lot of money with warrants, yet can also suffer considerable losses. Before you venture into this market, you should therefore familiarise yourself with the basics. Warrants are categorised as derivative financial instruments. This means that every warrant is linked to an underlying asset. The performance of the underlying is reflected in the price of the warrant.

It is generally only worth buying a warrant if you think the price of the underlying asset is going to change considerably. Warrants can be based on a variety of underlying assets, such as equities, commodities, treasury bonds, currencies, even on climate events. Initially warrants listed on the ISE will be limited to ISE-030 constituents, equity baskets constructed from ISE-030 constituents, and ISE headline indices Even though the number of these underlying shares is limited, issuers will issue far more warrants that the number underlying constituent shares as they list warrants with different maturities and strike prices. Accordingly with so many varied instruments, investors are bound to find exactly what they are looking for.

The direction in which investors expect the price to move will determine whether they buy a call or a put warrant. This is because the owner of a warrant has the right to either buy or sell the underlying (also referred to as the underlying asset) at a certain price (strike price) from or to the issuer within a specified period of time (maturity) according to a certain ratio (exercise ratio) on the capital market, or else receive an equivalent monetary amount (see below for a further explanation).

Investors therefore have to decide whether to purchase call warrants (calls – right to buy) or put warrants (puts – right to sell). Calls are typically bought when the price of the underlying is expected to rise, while puts are opted for when the price is expected to fall. For put warrants, the right to sell this underlying at a specified price therefore becomes more valuable the lower the underlying’s price.

Those in possession of a warrant have the following three choices: they can either let it expire, sell it or exercise it. Should you decide in favour of exercising your warrant, you must not forget an important difference between American and European warrants, namely that you may exercise the former at any time prior to expiry and the latter only on the expiry date. If all other indicators are identical, European warrants often sell for less than their American counterparts as the right to exercise at any time presents an unquestionable advantage.

Nowadays, many warrants are settled by means of cash settlement rather than physical delivery. Cash settlement was first introduced because physical delivery was not possible for certain warrants, e.g. index warrants – you cannot physically deliver the ISE 30 Index constituents for small warrant holdings. Now, however, with the streamlining of settlement procedures, even warrants where physical delivery is possible have a cash settlement feature. Initially all warrants issued on the ISE will be cash settled.

**The value of a warrant**

Warrants can include various features designed to accommodate investors’ expectations. Below are a number of terms used for these features.

The price of a warrant is comprised of the intrinsic value and the time value. The latter is the difference between the warrant price and its intrinsic value. The time value is the consideration payable for the “lifetime” of the warrant. The longer the time to maturity of the warrant, the more valuable it is. This is based on the hope or assumption that a change in price of the underlying will lead to an increase in the differential amount achieved up to the expiry date. As the time to maturity of an warrant decreases, its time value will thus decay at an accelerating rate, ultimately towards zero. The price of the warrant upon expiry will be no more than its intrinsic value.

A warrant always has an intrinsic value – also known as parity – if it can be exercised at a profit. This is determined by whether the spot price of the underlying is above or below the strike price. In this instance, a difference is made between warrants that are in the money, at the money or out of the money.

Call warrants are referred to as being “in the money” when the strike price is below the current share price. The fact that the investor can, in this case, use the warrant to purchase the share at a cheaper price means that the warrant has a value, i.e. is “in the money”. Likewise for put warrants, they are referred to as “in the money” when the strike price is above current share price. If the strike price and share price are identical, a warrant is considered to be “at the money”. A call warrant with a strike price that is higher than the current share price or a put warrant where the strike price is below the current share price are referred to as being “out of the money”.

In the case of out-of-the-money warrants, i.e. warrants with no intrinsic value, the price simply equals the time value. If the warrant remains out of the money until maturity, the time value will shrink to zero and the warrant will expire worthless.

Out-of-the-money warrants are ultimately a far riskier purchase than warrants with intrinsic value. Warrants that are far out of the money and due to expire soon are therefore highly speculative as they carry the highest risk of total loss. These warrants will only yield a profit if the price of the underlying makes a swift and sharp move in the desired direction. The probability of this happening has to be assessed in each individual case.

The following examples best illustrate the concepts of “in the money”, “out the money” and “at the money”

Underlying | Type | Strike Price | Underlying Price | Maturity | Warrant Price | Intrinsic value | Time Value | Moneyness | |

1 | ABC | CALL | 6,00 | 6,50 | 6-months | 0,85 | 0,50 | 0,35 | In the money |

2 | ABC | CALL | 6,00 | 6,50 | 10-months | 1,15 | 0,50 | 0,65 | In the money |

3 | ABC | CALL | 7,00 | 6,50 | 6-months | 0,55 | 0,00 | 0,55 | Out of the money |

4 | XYZ | PUT | 5,00 | 5,30 | 3-months | 0,25 | 0,00 | 0,25 | Out of the money |

5 | XYZ | PUT | 5,00 | 4,25 | 4-months | 0,95 | 0,75 | 0,20 | In the money |

6 | XYZ | PUT | 5,00 | 5,00 | 2-months | 0,20 | 0,00 | 0,20 | At the money |

7 | ISE-30 Index* | CALL | 65.000,00 | 67.000,00 | 3-months | 2,80 | 2,00 | 0,80 | In the money |

**The index warrant has a multiplier of 1:1000, i.e. 1000 warrants constitute one index basket*

Example 1 above shows a call warrant on ABC, where the current price of the underlying is above the strike price. This warrant is “in the money” and has an intrinsic value of TRY0.50 (underlying price less strike price). In this example the warrant is trading at TRY0.85, which is greater than the intrinsic value, implying a time value of TRY0.35. Time value is the value attached to the possibility that the underlying’ price will rise before the warrant expires.

Example 2, a call warrant on ABC with the identical terms to example 1, save for the maturity date, best demonstrates the fact that the longer the time to maturity the greater the time value of a warrant. The underlying has a longer time to perform and hence the higher time value.

Example 3 shows a call warrant with no intrinsic value (the current price of the underlying is below the strike price) and this warrant is said to be “out of the money”. The time value of TRY0.55 reflects the possibility that the underlying price could rise above the strike price in the 6 months to maturity.

Example 4, a put warrant on XYZ is said to be “out of the money” as the warrant has no intrinsic value – the current underlying price is above the strike price. Put warrants give investors the right to “sell” the underlying share and therefore have intrinsic value only when strike price is higher than the current underlying price. In this example the time value is relatively small as the warrant only has 3 months to expiry. Example 5 shows a put warrant that is “in the money” as it has intrinsic value of TRY 0.75, whilst Example 6 shows a put warrant where the strike price is equal to the current underlying price. This warrant is said to be “at the money”. Example 7 is an example of a warrant on the ISE -30 Index.

**The effects of price fluctuations**

Volatility is one of the major factors influencing warrant pricing and should therefore be monitored constantly. Volatility is a measure of how much the price of the underlying fluctuates.

One of the key premises of modern warrant pricing theory is that a warrant will be more valuable the greater the range of price fluctuations or volatility of the underlying. This is because the probability of the warrant appreciating in intrinsic value increases the more dramatic the fluctuation in the price of the underlying. Simply demonstrated, assume we have two warrants on different underlying shares that have less than 3 months to expiry and are 20% out of the money. Let’s assume that the one underlying is very volatile and that share price moves of 5% or more in a day are common, whilst the other underlying is far less volatile so that share price movements rarely exceed 1% a day. It is obvious that the probability is far greater that the warrant on the volatile share will end in the money than the warrant on the less volatile share. All things being equal then one can expect this warrant to have a greater value on account of this higher volatility.

As it is possible to make an exact calculation of historical, realised volatility of the underlying, this is an important indicator for assessing expected and implied volatility, which are both priced into warrants. Past fluctuations can only ever serve as a guide, however, as the rate of volatility can change very rapidly. All traders have experienced this at some point or another. For example, a surprise profit warning that strips 30 percent off an otherwise conservative or even dull stock has a major impact on the price of calls and puts it underlies.

The nature of these events is that they come as a surprise. All warrant traders look at the historical volatility of warrants traded at a particular time on the market and draw their own conclusions as to their implied volatility. The latter has a considerable impact on warrant pricing. This means that conclusions on the interdependency between the price of a warrant and that of its underlying – expressed in dynamic indicators – can only be applied as long as the market view of implied volatility stays the same.

Buying warrants just before a sharp rise in volatility can prove very lucrative. Let us assume, for example, that you acquire a put on an automotive stock (right to sell) just before the company releases a surprise profit warning. Previously classed as a relative non-mover, the stock then sheds 25 percent overnight. As the owner of that put, you stand to gain not only from the expected fall in the price of the underlying but also from a sharp rise in volatility. Background: The increase in volatility when the markets are on a sharp downward slope is far higher than when the markets are growing rapidly.

Following the same reasoning, you can also suffer nasty losses by buying warrants on financial assets that are extraordinarily volatile. Continuing our example, let us now assume that the share price of a similar automotive stock climbs from TRY8.50 to TRY10.50 following a substantial increase in earnings estimates. You now decide to buy a call warrant because you expect this strong rally to persist. Instead, the share price remains at the same level for weeks. Although the underlying has not fallen in price, calls on this stock will lose value due to the return to a lower level of volatility. In the worst-case scenario, the share price could rise slightly while the calls continue to lose value because of the lower implied volatility. In this example you would also be adversely affected by the loss of time value.

As the level of volatility during bear markets tends to rise faster than in bull markets, the above also applies, and perhaps even to a greater extent, to markets following a crash. This is because downside trends are often faster and more furious than upside trends.

The following table summarises how factors such as price movements in the underlying, volatility, interest rates, dividends and time to expiry affect a call and put warrants price.

Variable | Changes in variables | Changes in call warrant price | Changes in put warrant price |

Underlying share price | é | é | ê |

Dividend expectations | é | ê | é |

Volatility | é | é | é |

Interest rate | é | é | ê |

Time to expire | ê | ê | ê |

The value of a warrant is influenced by five factors outlined in the table above. The arrows indicate which direction the value of the warrant will move in response to a change in the corresponding factor

The share price - this is the key driver of the warrant price as discussed above.

Dividends – investors in warrants do not receive the dividends paid on the underlying shares. However, in valuing warrants, the Issuer will estimate the expected dividend stream. This means that warrants do not dramatically fall in price when the underlying share trades ex dividend. The terms of warrants are adjusted to accommodate the changes that may arise from scrip issues so that the warrant investor is not prejudiced.

Volatility – this is the standard measure of risk on the underlying shares. The higher the volatility, the higher the risk on the underlying shares and therefore the more expensive the warrant will become.

Interest rates – for each call warrant issued, the issuer allocates funds to purchase underlying shares. If the cost of borrowing (the interest rate) increases, this will be reflected in a corresponding increase in the warrant price. Similarly, a put warrant will decrease in value when interest rates rise.

Time to expiry – the greater the time to expiry, the greater the value of the warrant. This is because the warrant has more time to perform.