Option conditions

Option conditions

Warrants are securities. Today, they are mostly no longer issued in the form of effective certificates, but are instead deposited as global certificates and have quite different equipment features. The issuer, often a commercial bank or brokerage firm, specifies the exact specifications in the option terms.

In particular, these provide information about the underlying and price, type (European or American), subscription ratio (option ratio), term (option period) and special features such as a “money-back guarantee”, and are available to everyone free of charge in the form of a sales prospectus made available. Commercial banks and brokers also publish summaries of the option terms in the form of financial notices.

Classification

Warrants can be classified using the criteria “Underlying”, “Structure”, “Form of issue” and “Underlying”.

Warrants after the underlying

Warrants after the underlying

Initially, the underlyings for warrants were primarily shares. Large US stock corporations issued so-called stock-option warrants in the 1920s, which entitled the holders to acquire one or more shares in the respective company within a certain period and at a predetermined price. Nowadays, both call and put warrants are in circulation. They refer to different underlyings. The most important underlying financial objects are stocks and indices (share and index notes), interest rates or specific bonds (interest notes) as well as currencies (currency notes) and derivatives (notes on derivatives).

Interest coupons (structure)

Interest coupons (structure)

Compared to other notes, coupons have a special feature. They can be based on both bonds and interest rates. In the case of bonds, the strike price is a price and the intrinsic value is the difference between the price and the base price. Just like for stock or currency options, for example, the buyer of a call hopes that prices will rise, while the buyer of put will hope that prices will fall. In other words, call buyers expect interest rates to fall, and put buyers expect them to rise, which is due to the inverse relationship between interest rates and prices.

It is basically the same with notes based on interest rates. The call buyer benefits from falling interest rates, the put buyer, however, from rising. However, since the notes are based on an interest rate and not a price, a call has an intrinsic value if the interest rate on the exercise day is below the base rate, and a put if the opposite is true. The strange thing about warrants on interest rates is, therefore, that the purchaser of a call option (put option) expects the value of the underlying to decrease (increase). However, it should be borne in mind that the buyer of an “interest rate call” secretly, like the buyer of a “bond call”, is betting on rising prices, which in turn are caused by falling interest rates.

Basket option certificates

If a warrant is not based on a single share, bond or currency, but on a number of similar underlyings, such as ten different stocks from the automotive industry or five different currencies, this is also called a basket warrant.

Plain vanilla versus exotic warrants (structure)

Warrants with an underlying of the same type, for example equity, currency or index certificates, are either “simply structured”, “plain vanilla” in English, or “exotic”. Plain vanilla notes simply certify the right to buy or sell the underlying, in most cases there is cash settlement. The design of exotic notes sometimes differs significantly from the construction of plain vanilla notes. Exotics, for example, have a disproportionate leverage or expire worthless if a certain price threshold is exceeded. Depending on the distribution of opportunities and risks, the premiums understandably differ from those of plain vanillas. Compared to simply structured notes, they can possibly be higher or lower.

Classic versus bare warrants (form of issue)

Classic versus bare warrants (form of issue)

Warrants are either part of another security, such as a bond, a profit participation certificate or a share (“classic certificates”), or they are securities that are issued from the outset without another security, so to speak “naked”. For them, the term “naked” warrants is common.

Classic notes always certify the right to acquire a financial object, the underlying, within a certain period, the subscription period, at a fixed price, the subscription price. Therefore, they are never puts. The subscription right mainly applies to securities and is granted by stock corporations in order to make bond issues more attractive or to be able to raise debt capital on more favorable terms. The underlying securities mostly originate from the issuing company itself. Exercising a classic warrant on shares or bonds fundamentally leads to a change in the issuer’s capital structure. German stock corporations may therefore only issue certificates for the purchase of shares as part of a conditional capital increase. The approval of the shareholders is therefore always required.

In contrast to bare warrants, the underlying for classic notes is only created at the time of exercise. The issuer does not provide a pictorial explanation of the share or bond certificate until the option is exercised.

Naked warrants now represent the larger group of warrants. They certify both buy and sell options. The underlyings are already in circulation at the time the notes are issued, so that, for example, exercising a bare share call slip does not lead to an increase in the share capital of the AG concerned. This aspect can ultimately be neglected, since the issue conditions of naked warrants generally provide for cash settlement.

Covered versus uncovered warrants (underlay)

Covered versus uncovered warrants (underlay)

If the writer of a bare warrant has the underlying during the term of the bill, one speaks of a covered warrant or covered warrant. In principle, all those bare warrants that relate to specific assets, such as shares or bonds, can be issued as covered warrants. However, the term is generally only used in connection with bare share certificates.

The issues of covered share certificates are particularly interesting for insurance and investment companies. These generally have extensive securities holdings and can open up additional sources of finance by selling the warrants, especially if they are unlikely to be exercised.

 

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