Learning Curve: an introduction to inline warrants
Inline warrants are growing in popularity as a means of generating returns when volatility is low.
By Fabio De Zordo, head of structured, securities and flow products, and Fabian Ecker, equity derivatives trader, at UniCredit
Inline warrants are an investment product that enables investors to benefit from the stability of a certain underlying asset; usually a stock or stock index. They are best used during calm market phases where returns are otherwise limited by a lack of volatility.
Where standard investments usually benefit from changes in stock prices (the proverbial 'buy low, sell high' scenario), inline warrants turn things around and enable the investor to capitalise on a lack of change in stock prices. This strategy would have worked out well during the past months with indices trading sideways, as shown for the Euro Stoxx 50 below.
At the moment there are about 25,000 inline warrants on different underlyings listed on German exchanges, the biggest market for inline warrants in Europe.
Over the past few years, this product category has evolved as different banks have begun issuing products on a broad range of underlyings, including equity, FX, commodities and other categories. They also have different parameters, like narrow or broad corridors, maturities that range from short-term (one to three months) to long-term (up to 1.5 years) and varying maturity dates.
How do they work?
Inline warrants depend on fluctuations in the price of a certain underlying. The products are offered with upper and lower knock-out barriers — maximum and minimum price thresholds that the underlying must not breach for the duration of the contract.
This creates a corridor within which the underlying price must remain in order for the warrant to pay out upon maturity. There are two possible outcomes:
Scenario 1: The underlying price remains within the corridor created by the upper and lower knock-out barrier and a fixed redemption is paid out to the investor at maturity.
Scenario 2: The price drops below the lower threshold or rises above the upper threshold, triggering a knock-out event. This causes the warrant to expire worthless on that date and the amount invested is lost.
By virtue of including both upper and lower knock-out barriers, inline warrants can generate above-average profit opportunities in low-volatility environments — with higher yields rewarding greater risk. Additionally, it is relatively easy to understand and calculate the potential return. For instance, 1,000 inline warrants priced at €6 each and yielding €10 if they don’t hit one of the barriers will give a return of exactly €10,000, or 66.7%.
The flipside of commanding a higher yield is shouldering additional risk. Since inline warrants include not one but two knock-out barriers, the risk of suffering a loss of investment is higher than for other investment products — especially compared to those that use only one knock-out barrier, such as 'stay high' or 'stay low' warrants.
The pricing of an inline warrant is driven by three factors. First is the time to maturity. As the clock ticks down, an active inline warrant becomes increasingly valuable, reflecting the fact that it’s becoming increasingly likely to pay out.
This is shown in the graph below, where it can clearly be seen that the fair value is converging to 100%. Since the width of the corridor is around one one-year standard deviation of the underlying, the fair value of a product with one year to maturity is very small.
From an investor’s point of view, this means inline warrants exhibit a positive time decay (theta), which is shown in the next graph. For products with a long time to maturity, where the underlying spot trades around the middle between the barriers, theta is smaller than for products with a shorter time to maturity.
For a very short time to maturity, theta virtually explodes close to the barriers and is more or less zero in the middle (since the redemption amount is almost reached).
The impact of the underlying price depends on where it is currently trading; between the lower barrier and the middle or between the middle and the upper barrier.
In the first case, delta, the ratio of the change in price of the warrant to the change in price of the underlying asset, is positive for the investor, because the further the spot moves away from the lower barrier, the more the price of the inline warrant increases.
As soon as the spot price rises above the middle, the sign of delta changes. The shorter the time to maturity, the greater the sensitivity to changes in the underlying price. For very short terms, this sensitivity reaches extreme values near the barriers and approaches zero while the underlying price remains near the middle.
This explains why the investor is exposed to spot moves, known as 'gamma short'. Gamma does not play a big role at the initiation of a product when there is a long time to maturity, because delta is fairly small and does not change a lot.
When close to expiry, gamma plays a big role near the barriers and might tend to infinity due to the risk of a barrier breach. If the spot is around the middle between the barriers, gamma converges to zero.
The last and one of the most important factors to influence the price of inline warrants is the implied volatility. In general, if implied volatility is high, the price of the product is low due to higher risk of a barrier breach, but increases with declining volatility.
Rising implied volatility therefore has a negative impact for investors. Also worth noting is that vega, the sensitivity to changes in the implied volatility, is highest for a product with medium time to maturity around the middle.
Depending on the investor’s risk profile he or she can choose the parameters of the warrant to create different variations. For example, the investor can change the distance between the upper and lower knock-out barriers. Setting them further apart will reduce the risk of a knock-out event — making the product more expensive, and thus resulting in a smaller potential return. Bringing the barriers closer together will increase the risk — making the inline warrant cost less with a higher potential return.
Turnover of inline warrants is particularly high in the German market (which is the biggest in Europe for private investor products), due to a large self-guided investor community and a long tradition of private investor products.
Inline warrants have also gained the attention of Italian and French investors since the launch of the products a few months ago. UniCredit is an active issuer of inline warrants and plans to extend the product range to more underlyings, namely commodities and FX.
Inline warrants are a simple-to-understand strategy for generating above-average yields during periods of low volatility. As theta-positive products, they converge to the redemption value over time, provided there is no barrier hit.
In the coming years, we expect to see growing customer interest — along with continued extension of the product universe to include an increasingly wide range of underlyings.