Covered Warrants I

Introduction| Course| Q&As | Recommended reading| Quiz | 970

12. Types of covered warrant III (exotics)

Warrants are flexible instruments which do not have to conform to completely standardised terms like options: they can be issued over a wide range of instruments, with a wide range of exercise prices, and with a wide range of special conditions. When warrant terms are made more complex, these warrants are usually called exotics, and naturally they appeal to the more experienced practitioners in the market.

It is wise to exercise caution when considering exotic warrant structures. The most important rule is as always to make sure you completely understand the product before you invest.

Barrier Warrants

One development of plain vanilla calls and puts is to add a price barrier to the terms. This style of warrant can also be called a capped warrant. The idea is that in addition to the usual terms including an exercise price and maturity, a barrier level is also incorporated, which can be high or low. Once the barrier price is hit, the warrant expires immediately, either providing a capped return, or in the case of knock out warrants, no return at all.

Call barrier warrants can be up and out warrants which may expire early if the asset level equals or exceeds an upper barrier level. In this circumstance a maximum return is payable. They can also be down and out, which means the warrants expire early if the asset level equals or falls below a lower barrier level. This can mean that the warrants will immediately expire worthless, or if the exercise price is below the barrier level, that a minimum payout is made. Put warrants can use similarly structured barriers.

There are also knock in barrier warrants where the breach of a barrier level causes a change in the terms of the warrants.

Barrier warrants are highly individual by nature, which is a good point at which to repeat the mantra that it is essential to check individual term sheets for precise details.

Corridor Warrants

Essentially, corridor warrants are designed to take advantage of times when investors believe an asset price will trade within a narrow band, remaining fairly static. They have in the past been called AIR corridor warrants – accrue income in range. The longer the asset stays within that band, or corridor, the more value is accrued and the more the warrant is worth. Usually a set payment will be made for each day the asset value stays within the specified band, up to a final maturity date. Effectively these are a development of barrier warrants – in this case there is both an upper and a lower barrier.

Example

SG Dow Jones Corridor Warrants; spot index level 10,200
First listed September 10th 2001 in Amsterdam
Tranche A: corridor 9500-11,500; issue price EU4.08; pay out EU0.05 per day in range; maturity 04/02/02
Tranche B: corridor 10,000-11,000; issue price EU2.77; pay out EU0.05 per day in range; maturity 04/02/02

Trigger Warrants

Trigger warrants are not common, but they are possible. These warrants specify a particular event in their terms, such as the underlying asset reaching a specified level. If the trigger event occurs then a fixed payout is made; and if not the warrant expires worthless. These ‘all-or-nothing’ warrants have a lot in common with a straightforward wager. Warrant analysts will not generally encourage comparisons with horse racing, or with Russian roulette, but in this case they might not be entirely without validity.

1. Introduction 2. What are covered warrants? 3. Comparison between corporate warrants and covered warrants 4. Advantages of warrants 5. Advantages of warrants – the magic of gearing 6. Disadvantages of warrants 7. Advantages & disadvantages - a summary 8. International warrants markets 9. UK warrant market 10. Types of covered warrant I (warrant terms) 11. Types of covered warrant II (underlying assets) 12. Types of covered warrant III (exotics) 13. Information on warrant terms 14. Warrant trading 15. Warrant pricing 16. Basic analysis I (underlying asset) 17. Basic analysis II (prices and terms) 18. Basic analysis III (gearing) 19. Basic analysis IV (intrinsic value) 20. Basic analysis V (premium) 21. Advanced analysis I (Black-Scholes Model) 22. Advanced analysis II (volatility) 23. Advanced analysis III (the greeks) 24. Risk 25. Trading strategies 26. Tax 27. Conclusion

Recommend Reading

• Andrew McHattie on Covered Warrants

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