Covered Warrants I

Introduction| Course| Q&As | Recommended reading| Quiz | 963

21. Advanced analysis I (Black-Scholes Model)

If you are not mathematically minded, you may wish to skip this section, or at least the more difficult parts of it. You can deal in covered warrants successfully without entering a labyrinth of unintelligible formulae. Advisers and information services can do the work for you, but for many investors there is a sense of satisfaction to be gained from understanding and performing the entire process of analysis. It is up to you.

Black-Scholes

Formulated in 1973 by Fischer Black and Myron Scholes, and subsequently developed by Robert Merton, the Black-Scholes model has become standard usage for analysts valuing options or synthetic warrants. It is the benchmark against which all other option pricing models are compared.

Whether or not you believe it provides good answers is another matter, but it would be wrong to ignore it even if you doubt its efficacy: if everyone else is using it to predict prices, it will to some extent be self-fulfilling.

It is the mother and father of option pricing techniques, widely used to calculate ‘fair value’ prices in many forms of derivative markets – not just the European-style call options for which it was first created.

Before placing absolute faith in the model, however, it is best to remember that this is a theoretical model which is based on a range of assumptions to simplify matters. The principal assumptions are:

1. No dividends from underlying asset
2. European exercise terms (so warrants will not be exercised early)
3. Efficient markets
4. No commissions
5. Constant volatility
6. Constant interest rates
7. Returns are lognormally distributed

These basic formulae were never intended to work as catch-alls for all forms of derivatives and option-like instruments, and sure enough, the key assumptions are often violated by covered warrants. So the formula has moved on. There have been a number of adaptations, extensions, and developments of the basic Black-Scholes model over the years.

Don’t complain when covered warrant issuers’ determination of fair value differs from the results gleaned from the basic Black-Scholes formulae. They will probably be using subtly different models, and perhaps taking other factors into account, such as their listing, hedging and financing costs.

A better approach is to regard the Black-Scholes results as an approximation and to use them to gauge whether market prices are in the same realm. If not, then some further investigation might be merited.

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

Tools
	Black-Scholes Variation calculator

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