The Bull

Thursday 18

January, 2018 2:45 PM



Warrants question

Can you please explain how instalment warrants are priced?

Can you please explain how instalment warrants are priced? Matt Comyn, CommSec

A number of factors are taken into account when determining the price of an instalment warrant. Not only are there pricing components to consider, but influences affecting price movements also need to be factored in.

Let’s look at the four components which make up the price of an instalment:

1. Capital component

this is equal to the share price less the loan amount.

2. Prepaid interest

this is the interest on the loan amount until the next reset, annual interest date, interest drawdown date or maturity date (depending on the type of Instalment). This may potentially be deductible against an investor’s income.

3. Put option cost

this is this cost which enables an investor to walk away from making the final payment if the share price falls below the loan amount. In simple terms, it is the feature which provides investors with ‘protection’.

4. Borrowing fee

this is the fee payable to the issuer to acquire the loan.

Factors Affecting Price Movements - during the life of an instalment, there is a close relationship between movements in the price of the instalment and movements in the value of the underlying share. As the price of the underlying share moves up or down, the price of the instalment will move in the same direction.

In addition to the share price, an instalment price will also be affected by a number of other factors including:

Dividends - when an underlying share goes ex-dividend, the instalment will also. Generally speaking, this means that the first instalment price (excluding self-funding instalments or managed fund instalments) will fall by the amount of the dividend paid on the date it goes ex-dividend (other things being equal). In the case of a self-funding or managed fund instalment, dividends are applied to reduce the loan amount, so the first instalment price should not change on the ex-date.

Changes to forecast dividends may also affect the price of an Instalment by increasing or decreasing the price of put protection. Generally, an increase in future expected dividends will increase the put protection cost and overall instalment price.

Volatility - generally speaking, the higher the volatility of the underlying share, the higher the cost of the put option and subsequently the higher the price of the Instalment.

Time to expiry - over the life of an instalment, the value of the interest and put option components will slowly decline until they reach zero at the reset or maturity date. Normally, the greater the loan amount the more expensive the interest and put option costs will be and hence decay will occur much faster. This is often the case with highly leveraged Instalments which can have an LVR of up to 95%.

Interest rates - all other things being equal, when interest rates increase, so does the prepaid interest component, making the Instalment price rise. Conversely, when interest rates fall so will the value of the Instalment.

Delta - the ‘delta’ of an Instalment is the change in the value of the instalment relative to movements in the underlying share price, and is represented by a percentage of 0% to 100%.

Instalments are generally deep in-the-money which means that the price of the underlying share trades above the loan amount. The difference between these two values is also known as intrinsic value. E.g. if the share price is $10.00 and the loan amount is $7.00, then the intrinsic value of the instalment is $3.00.

It is important to note that Delta is not constant. It will change over time as the relationship between the loan amount and the underlying share price changes. Regularly geared instalments have a delta very close to 100%, meaning that as the underlying share price rises or falls, the instalment should rise or fall by approximately the same amount.

Highly-geared instalments have deltas of less than 100% which means the price of a highly geared Instalment will not move by as much as that of the underlying share.

By Matt Comyn, General Manager, CommSec

Disclaimer: The information in this article is general in nature and does not take into account any investor's particular objectives, financial situation or needs. In consider its appropriateness, investors should read the relevant product disclosure statement and consult a financial adviser before making an investment decision.


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