The Age of Wobble: The Significance of Premium to Warrants

Jinxin

We often consider the premium when trading warrants, so as to judge whether it is cheap enough and whether the risk is big enough? In fact, what does premium mean to investors?

To understand the meaning, we can start from the formula of premium:

[Exercise price+(warrant price × conversion ratio)] - positive share price premium (warrant)=× 100% positive share price - [Exercise price - (warrant price × conversion ratio)] premium (put warrant)=× 100% positive share price

What does this mean? Taking the warrant as an example, if the formula is divided into two parts, the first part is: [exercise price+(warrant price × conversion ratio)], which can be referred to as [total exercise cost], in other words, the premium is: how much the positive shares need to rise, and investors can buy the warrant at the current price and hold it until the expiration date to be flat.

For example, the market price of an HSBC subscription certificate is 0.77 yuan, the exchange rate is 10 to 1, the exercise price is 117 yuan, and the current price of HSBC is 116.5 yuan. Through the formula, we can get the premium of the certificate is 7%.

[117+(0.77 × 10) - 116.5] Premium (put certificate)=× 100%=7% 116.5

This means that if an investor buys the HSBC warrant at the current price and holds it until the maturity date, the HSBC share price will rise by 7% from the current price of 116.5 yuan to 124.7 yuan, and the investor will be able to just make a draw.

If there are two warrants, the premium of warrant A is 10%, and the premium of warrant B is 20%. The premium of warrant B is high, and the positive shares need to rise to a larger extent, so that the warrants held by them can reach a draw when they expire. In this view, the purchase of warrant A will be more cost-effective. However, if the investor is just quick in and quick out, it is not necessary to hold the warrant until its maturity. In many cases, the investor will only hold the warrant for 5 or 10 days and then sell out arbitrage or stop erosion in the market. The premium is of little significance to investors.

However, in some cases, the premium is of reference value. The following is the case where the two premiums become meaningful.

First, suppose there are two warrants. The related assets, exercise price and maturity date are all the same, but one of them has a higher price and the calculated premium is also higher.

The terms of the two warrants are exactly the same, but the price of one warrant is high. The only explanation is that its extension amplitude is high, that is, the warrant price is expensive. In this case, the premium has reflected the height of the extension amplitude. Two identical goods, of course, choose the cheaper one. Note that this is the only case. You can also know which warrant is cheaper and which is more expensive just by looking at the premium. However, in reality, there are few warrants with exactly the same terms, and the extended amplitude is actually the index for comparing the prices of warrants.

Second, we said that "if investors do not intend to hold warrants until their maturity, the premium level does not mean much to investors", but conversely, if investors have the opportunity to hold warrants until their maturity, they may need to refer to the premium level. Generally speaking, several investors may hold warrants until their maturity.

1. The purchase is short-term warrants, and investors have always targeted the value of warrants when they expire.

2. Long term warrants are purchased, but investors know that their discipline in stopping erosion and profit is low, so they should expect that in the worst case, if they really hold warrants to the maturity date, they will be flat.

3. In consideration of hedging or other reasons, investors need to hold warrants until the maturity date.

If the investor decides (or is forced) to hold the warrant until the expiration date, in fact, he has expected to give up all the time values, purely aiming at the increase of the positive shares before the expiration of the warrant. Under this principle, the premium becomes relatively meaningful. Because the premium (warrant as an example) is defined as how much the positive shares need to rise, investors can buy the warrants at the current price and hold them until the expiration date. The lower the premium, the easier it is to repay the principal. In other words, the higher the chance of making money at maturity (above the positive share price).

In this case, buying warrants at a premium is not based on the level of the warrant itself, but on which one is easier to pay back (although that warrant may be the most expensive one in the price). Strictly speaking, investors do not make decisions with the mentality of buying warrants, but only treat warrants as positive shares bought at a lower price. Data such as the extension amplitude and the actual leverage ratio are no longer useful, because investors are no longer profiting from short-term changes in positive shares, but only focus on whether the positive shares can hit the right spot when the warrants expire, This is totally different from the goal and mentality of general investment warrants.