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Fill-up on knowledge warrants Product information Telephone info line E-mail Internet Magazine (0 69) 9 10-3 88 07 [email protected] www.db-xm.com X-press (published every month) Free of charge Price information Teletext n-tv Text 770 Reuters DBMENU Telephone price line: 01805/950955 Address This brochure has been printed on environmentally friendly paper. Deutsche Bank AG X-markets-Team Große Gallusstraße 10–14 60272 Frankfurt am Main The sponsors of the indices mentioned in this brochure have no relationship to the products on offer other than the licensing of the indices. They do not endorse, recommend or promote them. All trademarks for the aforementioned indices are owned by the respective index sponsor. Deutsche Bank AG D-60262 Frankfurt am Main 003 88039 00 warrants Contents Knowledge is power Situation Knowledge is power 3 Solution Fill-up on knowledge 4 Over the last few years, there is hardly a single financial instrument that has whetted investor appetites as much as the warrant. Warrants can be used to make substantial gains, yet they can also lead to considerable losses. Anyone wishing to invest in warrants needs to know exactly how they work and what risks they typically Success factors The warrant – an everyday product The basics Expensive or not? Dynamic indicators Types of warrants Warrant trading and the role of the issuer Strategies Finding the right warrant FAQs Appendix Tax treatment of warrants held as private assets Internet service Recommended literature Warrants – glossary* 5 10 15 18 22 25 29 34 36 entail. Losses have all too often been the result of a lack of experience in dealing with these products. Only those who know what factors can influence the price of warrants and, above all, how these factors influence them, can trade successfully in these instruments in the long run. 38 40 41 * The warrants glossary contained in the appendix is an integral part of this brochure. 2 Contents Situation 3 Fill-up on knowledge In order to explain the origins, background and trading of warrants, we have taken an example from everyday life. The scenario we have developed, involving a car owner needing to fill-up his tank and a customer-oriented pump attendant at a petrol station, is exactly what investors experience when they trade in warrants on the stock exchange. “Fill-up on knowledge” is therefore the motto of this brochure, which we hope will leave you tanked up with information and ready to venture into the world of warrants. 4 Solution The glossary enclosed at the end of the brochure should help you on your way. This booklet contains a list of definitions briefly explaining some of the key terms and indicators used in warrant trading. These definitions have been arranged in alphabetical order to ease your search and, read in conjunction with this brochure, should ultimately help you build up and increase your knowledge of this subject. The X-markets team at Deutsche Bank hopes you enjoy the ride. The warrant – an everyday product Option contract at a petrol station Option contract at a petrol station Limited risk – no further obligations The best way of explaining the origins and workings of warrants is to take an example from everyday life. Let us assume that you have just bought your dream set of wheels – a top-of-the range sports car with a powerful engine. Your initial enthusiasm is decidedly short-lived, however, when you arrive at the petrol station to fill-up your new car only to discover that a litre of premium petrol is going to set you back a whole euro. Suddenly remembering what has been written in the press over the past few weeks about rising crude oil prices in Rotterdam as well as the petrol tax, you are forced to reckon with the price for a litre of premium petrol hitting ¤1.50 or perhaps even ¤2 within the next two years. Your heart well and truly sinks as you realise that your dream car, depending on how fast it is driven, consumes between 15 and 20 litres per 100 kilometres. Market value of the options Maturity of the options Future expectations Playing the stock exchange You then have a flash of inspiration and enter into the following agreement with the owner of the petrol station. You acquire the right to buy 5,000 litres of premium petrol at ¤1 per litre over the next two years. This means you have purchased 5,000 petrol options, each entitling you to buy a litre of petrol under the agreed conditions. The rest of the deal with the owner of the petrol station works as follows. You pay an immediate ¤0.10 per litre for the agreed volume. The right to buy 5,000 litres of premium petrol at ¤1 per litre at any time within the next 24 months therefore costs you ¤500. You also agree with the other party to this agreement that you may sell your options, in part or in whole, to another car-owner at any time. At the end of the day, the petrol station owner is not really concerned who he sells the 5,000 litres to. Success factors 5 Limited risk – no further obligations If the price of petrol were to rise to unexpectedly high levels over the agreed two years, you would be in a position to make a huge profit by buying 5,000 litres of premium petrol at well below the market price. If the price rose to ¤2 per litre, you could also consider selling your options, which, initially bought for ¤500, would then be worth ¤5,000. This would be a great deal all-round, and what is more, if the price of petrol were to fall, your risk would be limited to the sum needed to purchase the options. If the price per litre dropped to ¤0.80, for example, you would not be obliged to buy the 5,000 litres for ¤1. In this instance, the options would be worth nothing and expire worthless if the price of a litre of petrol remained below ¤1 for the term of the option contract. Let us now assume that during the agreed period of two years, the price of premium petrol for your dream car were to fall dramatically to rest at ¤0.70. In this instance, you would not make use of your right to buy 6 Success factors 5,000 litres of petrol at ¤1 and would let the options expire. You would then have to assume the total loss of the sum paid for the options, i.e. ¤500. This loss would have been limited had you sold the options after a few months. If the petrol price were to shoot up to ¤2, you would have the following choice. Either you could continue to fill your sports car with petrol costing a mere ¤1 per litre or you could sell your options and make a large profit. Do not forget that as the buyer, you simply have rights, whereas the pump attendant, as the seller, has rights and obligations. Market value of the options Three months later, during a routine trip to your local petrol station, you notice that a litre of petrol now costs ¤1.20. The value of your options has therefore risen and, contrary to the other car drivers you meet at the pumps, you are happy at how things have turned out. Of course, all attention turns to you when they realise that you only have to pay ¤1 per litre. You tell them about the deal with the petrol station and a number of the higher-price payers then offer to buy some of your options. Something along the lines of a market then materialises. As most people fear that petrol prices are going to increase further, you could sell your options immediately for ¤0.30 per litre. The prevailing market value of each option, which you purchased for ¤0.10, is therefore ¤0.30. Maturity of the options The higher the petrol price per litre rises above ¤1.10 – i.e. above your profit threshold – the more your options are worth and the more profit you will make. Given that you may exercise your options at any time and actually receive delivery of the petrol, and that there are parties interested in buying your options from you, you are free to choose between purchasing the 5,000 litres of petrol over the two years at a significant discount to the prevailing market price or selling your options at the prevailing market price. The price the other car drivers are willing to pay will, of course, be higher the more expensive a tank of petrol becomes. If the price of petrol were to rise to ¤1.20, you would save ¤0.20 by exercising your options. However, the “market value”, i.e. what others would be prepared to pay for these options, is ¤0.30. There is a good reason for this, namely that three months ago you entered into an agreement with a two-year term, i.e. the options are still valid for another 21 months. During this period of time, the price of petrol could rise to unexpectedly high levels. It therefore follows that the right to buy petrol at ¤1 per litre for another 21 months is worth more than the right to do this only for another two days, for example. Another feature of your petrol options is that you and the pump attendant have agreed to physical delivery. This means that upon exercising the options, you actually receive physical delivery of the underlying, in this instance, the premium petrol. Success factors 7 Future expectations Enjoying your role as a warrant owner, you take your pride and joy for a spin one morning and need to refuel again. On the display board at the petrol station you notice that the price of premium petrol has gone up overnight from ¤1.10 to ¤1.30. This price rise is due to the Organisation of Petrol Exporting Countries (OPEC) making a surprise decision to reduce crude oil production, thereby sending prices on the crude oil market in Rotterdam through the roof and causing oil companies to react as they always do in these circumstances, i.e. by hiking petrol prices. Groups of drivers can be seen standing around the pumps embroiled in heated discussions. An air of panic abounds as everyone fears that petrol prices will continue to rise even higher. Now well known among local car drivers, you step onto the forecourt and become immediately surrounded by a 8 Success factors group of them wanting to buy your options for 60, even 70, cents per litre. A particularly worried driver offers to buy 2,000 options for as much as ¤0.80. A few days later and the situation is different. Premium petrol has indeed risen to ¤1.35 a litre, yet no one expects prices to rise any further. The government has announced that, if necessary, it will lower petrol tax in order to keep prices stable. When you ask car drivers what they would be willing to pay for your options, the highest bid you receive is ¤0.50. It therefore goes without saying that expectations of future price trends for the underlying affect the value of an option. Hopefully, at the height of the panic, you will have accepted the highest bid and sold some of your options, leaving your angst-ridden buyers to curse the planned petrol tax cuts and bemoan their unlucky investment decision. Playing the stock exchange Since acquiring your petrol options, you have developed a keener interest in petrol price trends and their influences. One day, you read an interesting newspaper article about Deutsche Automobil AG. The carmaker is about to bring out an attractive, high-performance car that only consumes 2 litres per 100 kilometres. The model looks set to be a roaring success – especially given the further rise in petrol prices over the past weeks. In view of your positive experience of petrol options, you decide to try your luck with warrants traded on the stock exchange. The problem here is that there are a whole host of warrants available on Deutsche Automobil AG shares. All you have to do now is choose the right one. With the carmakers’ shares currently trading at ¤43, you follow a hunch that they will significantly appreciate in value and therefore opt for a call warrant. However, before you part with your cash, you want to know which warrants are lucrative. This involves looking at various key data on the risk/return profile of these financial instruments. These indicators can give you an idea of not only how much more expensive a warrant on Deutsche Automobil AG shares is than buying the shares directly but also how much the price of your warrant can fluctuate over time. These decisive details are outlined in the following sections. Departing from our petrol station scenario, we would now like to introduce you to the intriguing world of warrant trading on the stock exchange. Success factors 9 The basics The right warrant for the right investor. The choice is wide and the indicators varied. The right warrant for the right investor. The choice is wide and the indicators varied. The value of a warrant It is a well-known fact that investors can make a lot of money with warrants, yet can also suffer considerable losses. Before you venture into this market, you should familiarise yourself with the basics. Warrants are categorised as derivative financial instruments. This means that every warrant is linked to an underlying financial asset. The underlying asset performance is reflected in the price of the warrant according to a given ratio. The effects of price fluctuations VDAX® – the volatility index It is generally only worth buying a warrant if you think the price of the underlying asset is going to move considerably. On the German exchanges, warrants are issued on a variety of underlying assets, such as German and international equities, German and international equity baskets, German and international bonds, bond and share indices, as well as commodities, such as oil or precious metals. Index warrants, followed by equity warrants, comprise the largest segments with the highest trading volumes. Warrants on European and US 10 Success factors equities, in particular, can be found in large supply. Those who want to speculate on the price movements of blue chips listed on say the DAX®, the Dow Jones EuroSTOXX 50SM or the Dow Jones Industrial AverageSM, will not be disappointed with a lack of choice. In fact, the maturities as well as strike prices of these instruments are so varied that investors are likely to find exactly what they are looking for. to sell this underlying at a specified price therefore becomes more valuable the lower its price. Those in possession of an option have the following three choices: they can either let it expire, sell it or exercise it. Should you decide in favour of exercising your option, you must not forget that there is an important difference between American and European options, namely that you may exercise the former at any time prior to expiry and the latter only on the expiry date. With otherwise identical indicators, European options often sell for less than their American counterparts as the right to exercise at any time presents an unquestionable advantage. The direction in which investors expect the price to move will determine whether they buy a call or a put warrant. This is because the owner of a warrant has the right to either buy or sell the >underlying (also referred to as the underlying asset) at a certain price (>strike price) from or to the >issuer within a specified period of time (>maturity) according to a certain ratio (>exercise ratio) on the capital market, or else receive an equivalent monetary amount (further explanations below). Investors therefore have to decide whether to purchase >call warrants (calls) or >put warrants (puts). Calls are bought when the price of the underlying is expected to rise, while puts are opted for when the price is expected to fall. The right Success factors 11 Many warrants are settled nowadays by means of >cash settlement rather than physical delivery. Cash settlement was first introduced because physical delivery was not possible for certain warrants, e.g. index warrants – you cannot physically deliver the DAX®. Now, however, with the streamlining of settlement procedures, even warrants where physical delivery is possible have a cash settlement feature. accelerating rate, ultimately towards zero. The price of the warrant upon expiry will be no more than its intrinsic value. A warrant always has an intrinsic value – also known as parity – if it can be exercised at a profit. This is determined by whether the spot price of the underlying is above or below the strike price. In this instance, a difference is made between options that are >in the money, >at the money or >out of the money. The value of a warrant Warrants can have various features in order to accommodate investors’ expectations. Below are a number of terms used for these features. The price of a warrant is comprised of the >intrinsic value and the >time value. The latter is the difference between the warrant price and its intrinsic value. The time value is the consideration payable for the “lifetime” of the option. The longer the time to maturity of the option, the more valuable it is. This is based on the belief that a change in price of the underlying will lead to an increase in the differential amount achieved up to the expiry date. As the time to maturity of an option decreases, its time value will thus decay at an 12 Success factors In the case of out-of-the-money warrants, i.e. with no intrinsic value, the price simply equals the time value. If the option remains out of the money until maturity, the time value will shrink to zero and the option will expire worthless. Out-of-the-money warrants are ultimately a far riskier purchase than warrants with intrinsic value. Warrants that are extremely out of the money and soon due to expire are therefore highly speculative as they carry the highest risk of total loss. These warrants will only yield a profit if the price of the underlying makes a swift and sharp move in the desired direction. The probability of this happening has to be assessed in each individual case. The effects of price fluctuations Price fluctuations are one of the major factors influencing warrant pricing and should therefore be monitored constantly. One of the key premises of modern option pricing theory is that an option will be more valuable the greater the range of price fluctuations or >volatility. The reason for this is that the probability of the warrant appreciating in intrinsic value increases the more intensely the price of the underlying fluctuates. As it is possible to make an exact calculation of >historical volatility, this is an important indicator for assessing >expected volatility and >implied volatility, which are both priced into options. Past fluctuations can only ever serve as a guide, however, as the rate of volatility can change very rapidly. All traders have experienced this at some point or another. For example, a surprise profit warning that strips 30 percent off an otherwise conservative or even dull stock has a major impact on the price of calls and puts it underlies. The nature of these events is that they come as a surprise. All warrant traders look at the historical volatility of options traded at a particular time on the market and draw their own conclusions as to their implied volatility. The latter has a considerable impact on option pricing. Conclusions on the interdependency between the price of a warrant and that of its underlying – expressed in dynamic indicators – can therefore only be applied as long as the market view of implied volatility stays the same. Buying warrants just before a sharp rise in volatility can prove very lucrative. Let us assume, for example, that you acquire a put on an automotive stock just before the company releases a surprise profit warning. Previously classed as a relative non-mover, the stock then sheds 25 percent overnight. As the owner of that put, you stand to gain not only from the expected fall in the price of the underlying but also from a sharp rise in volatility. Success factors 13 Expensive or not? VDAX® – the volatility index Following the same reasoning, you can also suffer significant losses by buying warrants on financial assets that are extraordinarily volatile. Let us now assume that the price of a share climbs from ¤100 to ¤200. You now decide to buy because you expect this strong rally to persist. Instead, the share price remains at the same level for weeks. Although the underlying has not fallen in price, calls on this stock will lose value due to the return to a lower level of volatility. In the worst case scenario, the share price could rise slightly while the calls continue to lose value because of the lower implied volatility. This scenario, of course, is also affected by the loss of time value. 14 Success factors As the level of volatility during bear markets tends to rise faster than in bull markets, the above also applies, and perhaps even to a greater extent, to markets following a crash. The reason for this is that downside trends are often faster and more furious than upside trends. The recognised volatility index VDAX® measures the implicit volatility of options trading at the money and due to expire in 45 days. This index is predominantly influenced by the level of volatility expected by market participants. The volatility of the underlying tends to vary greatly. The implied volatility of the DAX® is therefore always a lot lower than the implied volatility of its individual constituents; one share price goes up, one goes down, ultimately having a balancing effect on the overall volatility of the index. From the wide range of warrants on offer, you now have to select the most suitable and least expensive From the wide range of warrants on offer, you now have to select the most suitable and least expensive Leverage What happens if …? Indicators are important, especially given the fast pace of option trading. You not only have to know what they are, you also have to be able to interpret them. Static indicators facilitate a qualitative price assessment of similar warrants at a given point in time. These indicators should only be used to compare warrants with similar features. One of the most important indicators when valuing options is the >premium. The major advantage of this indicator is that it can be easily calculated, thus providing a quick overview of which warrants are worth investing in. When buying options, the aim is to invest a small amount and then make a proportionally larger gain from any price movements of the underlying. The premium shows (in the case of calls) how much more it would cost to acquire the underlying by exercising the option rather than buying it directly. Success factors 15 Ultimately, however, an option is more valuable the longer its time to maturity and so this indicator, which fails to take this time aspect into account, does not say much at all. A more sensible way of comparing warrants would therefore be to calculate the premium per time unit, usually per year of time to maturity. But even this >annual premium does not quite hit the mark, the reason being that it is not seen in relation to the warrant. It is obvious, for example, that a premium of ¤1 has to be treated completely differently according to whether the warrant costs ¤5, ¤10 or ¤100. The best way to compare warrants using this indicator is therefore to calculate the >percentage premium. This premium shows how much more (in percent) it would cost to acquire the underlying by exercising the option rather than buying it directly, thereby serving as a useful criterion for comparing options. Asserting that an option is cheaper the lower the premium would nevertheless be too simple. A comparison of warrants is only 16 Success factors worthwhile if they have similar maturities and intrinsic values. Generally speaking, warrants with a high intrinsic value have low premiums and warrants with a low or no intrinsic value will only have a premium. A comparison based on the percentage premium serves two main functions. First, it provides investors with a quick and clear overview of which warrants are suitable. Secondly, if they have decided on a particular underlying, it enables them to compare the premiums of warrants with similar maturities and strike prices and then opt for the least expensive. Leverage Arguably the most widely known options indicator is >leverage, which shows the extent to which a warrant moves in line with its underlying. Current or simple leverage can be calculated by dividing the price of the underlying by the price of the option. If this ratio deviates from 1.0 or the underlying assets are denominated in a foreign currency (foreign equities), these factors are also priced into the warrants. Simple leverage is based on the assumption that price movements in the currency units of both the underlying and the option will be equivalent. This assumption, however, does not hold any weight. Let us take the example of a warrant granting the right to buy a share that is trading at ¤100. The strike price is say ¤200, and the option is set to expire in two months. The warrant costs ¤1, producing a simple leverage ratio of 100 ÷ 1 = 100. According to this ratio, a 10 percent rise in the price of the share to ¤110 would lead to a 1,000 percent rise in the price of the warrant to ¤11. In practice, however, this would never happen as the share price would still be a long way off the strike price of ¤200. If the share fails to move “into the money” within the space of two months, i.e. rises above ¤200, the option will expire worthless. This ratio is therefore only ever applicable to options with a high intrinsic value and not at all for those without any. It is for this reason that elasticity – also referred to as the omega – is mainly used nowadays (see next page). Another key indicator is the >break-even point, which shows the price level of the underlying at which the owner of the warrant will make a profit. Taking the example of a warrant costing ¤1, a strike price of ¤200 and a exercise ratio of 100:1, the share price would have to exceed ¤300 in order for the investor to make a profit. Success factors 17 Dynamic indicators Alongside static indicators, dynamic indicators also provide key information on warrants. Alongside static indicators, dynamic indicators also provide key information on warrants. Delta Dynamic indicators reflect changes in the price of an option relative to changes in the price, maturity or volatility of the underlying. As opposed to their static counterparts, they allow investors to make a forecast of the future price movements of warrants from a specific point in time and are generally determined using option valuation models. They are only valid for a short period of time and must be recalculated every time any key influential factor changes. Omega Theta Gamma Vega Rho Delta One of these indicators is the >delta, which belongs to the family of modern valuation indicators otherwise known as the “Greeks” because they are named after letters of the Greek alphabet. In modern option pricing theory, this indicator represents the sensitivity of the price of a warrant to the price movements of the underlying. The delta is calculated exactly using option valuation models derived from financial theory. The delta of a call warrant may lie between 0 and 1, and for a put warrant between –1 and 0. A delta of 0.70 means that, at an exercise ratio of 1:10, a ¤1 rise/fall in the 18 Success factors price of the underlying would lead to a ¤0.07 rise/fall in the price of the warrant. It can also be used as a rough guide to whether the option will have intrinsic value upon maturity and therefore not expire worthless. The probability that the above warrant will not expire worthless is therefore 70 percent. In mathematical terms, the delta is the first derivative of the warrant price with respect to the price of the underlying. particular attention. Using the Black-Scholes Model, which was named after its originators and later further developed, it is possible to calculate the “fair value” of an option. This value refers to the theoretically justified value at which there is an equal probability of making a profit or a loss. Unfortunately, valuation models such as these are founded upon basic assumptions that do not often hold true in real options markets. These assumptions include a constant interest rate, which is the same for credit and debit interest, and no constraints on short selling. Despite its flaws, however, the Black-Scholes Model has opened up a new perspective on the valuation of options. As a detailed discussion of this model is beyond the scope of this brochure, we have included a list of recommended literature in the appendix that addresses this subject in great detail. Omega Elasticity, which shows the percentage change in the price of the warrant relative to the percentage change in the price of the underlying, has also been represented by a Greek letter, namely >omega. It is obtained by multiplying the delta by the leverage ratio. The omega serves as a useful indicator yet, due to the fact that the delta changes with time, can only provide investors with a snapshot view. Over the past decades, dynamic indicators have been used to develop a series of option price valuation models. Along with the binomial model, the fair value model, devised by the American mathematicians Fisher Black and Myron Scholes, has drawn Success factors 19 Theta We have already mentioned that the price of an option is comprised of its intrinsic and its time value, and that the closer the expiry date, the faster the time value erodes. The >theta measures the loss of time value per unit of time, e.g. per day or week, assuming that the price of the underlying, along with all other parameters, remain the same until expiry. This indicator is usually shown as a percentage. A weekly theta of 1.5 percent means that, providing the underlying price moves sideways, i.e. the intrinsic value remains constant, the option will lose 1.5 percent of its value every week. The theta is very much dependent on whether the option is in the money, at the money or out of the money. A warrant with a high intrinsic value will have the lowest theta. At-the-money options will experience the fastest loss of time value as they move towards their expiry date. Generally speaking, the time value of a warrant will erode the most during the last three months until maturity. Investors must be constantly aware of this loss of value, which is solely attributable to the decreasing time to maturity. The closer a warrant 20 Success factors gets to its expiry date, the greater the price movement in the direction predicted by the investor must be in order both to offset the ever growing loss of value and ultimately generate a profit. In mathematical terms, the theta is the derivative of the warrant price with respect to time. Gamma Another key indicator is the >gamma, which defines the sensitivity of the delta to changes in the price of the underlying. The higher the gamma, the greater the reaction of the delta to such price movements. A gamma of 0.02 means that if the price of the underlying rises or falls by ¤1, the delta will change by 0.02 units. Options trading at the money have the highest gammas. Furthermore, the gamma is higher the shorter the time to maturity of the option. Mathematically speaking, the gamma is the first derivative of the delta with respect to the price of the underlying and therefore the second derivative of the price trend of the option in relation to the price movements of the underlying. Vega Rho The >vega shows the influence of fluctuations in volatility of the underlying on the price of the warrant. You will remember that volatility is the range of fluctuations in the price of the underlying within a given period of time. Along with the price of the underlying, the vega is the most important factor that can influence the value of an option. This indicator measures the degree to which the price of the warrant moves when the implied volatility rises or falls by one percent. A vega of 0.25 means that if the volatility of the underlying changes by one percent, the value of the option will rise or fall by 0.25 currency units, adjusted for the exercise ratio. As is the case with the gamma, options trading at the money have the highest vegas. In contrast to the gamma, however, the vega is higher the longer the time to maturity of the option. The >rho is the indicator used to measure the influence of interest rate changes on the value of options. When pricing options, the forward rather than the spot price is used. The forward price is comprised of the spot price plus a factor known as the costs of carry. This factor can be defined as the total costs of financing the underlying until the agreed expiry date of the option. These costs are affected mainly by the interest rate level. A rho of 0.50 means that the option price – adjusted for the exercise ratio – will change by ¤0.50 if the domestic interest rate rises or falls by one percentage point. When trading in currency options, the foreign interest rate must also be factored in. Euro/US dollar warrants, for example, have two rho indicators – one for the euro interest rate and one for the dollar rate. As extreme short-term interest rate fluctuations are very rare, however, the rho can often be disregarded for most other options. From a mathematical perspective, the vega is the first derivative of the warrant price with respect to volatility. In mathematical terms, the rho is the derivative of the warrant price with respect to the interest rate. Success factors 21 Types of warrants Underlying assets come in all shapes and sizes Index warrants Equity warrants Basket warrants Underlying assets come in all shapes and sizes Equity warrants Warrants can be acquired on various types of underlying and investors can use these derivatives to speculate on indices, equities, baskets, currencies, interest rates and commodities. The lion’s share of these warrants is based on single stocks. Calls and puts can be acquired on national and international equities with various strike prices and maturities, although liquid stocks are always a favourite. Index warrants Basket warrants Index warrants are based on the performance of share or bond indices. In the case of bond indices, the German REX® bond index plays a key role. The most popular underlying in this market segment, however, is the DAX®, i.e. the German share index containing the top 30 German stocks. Warrants on the American S&P 500®, the Nasdaq 100®, the Euro STOXXSM as well as the Japanese Nikkei 225 indices also attract investor interest, as do a small number of warrants based on other major foreign indices, such as the Austrian ATX®, the UK’s FTSE 100®, France’s CAC-40® or the China/Hong Kongbased Hang Seng®. Warrants on sector indices, such as the sub-indices of the DAX® or the Dow Jones Euro STOXXSM, also have their appeal. These warrants show parallels to index warrants in that they offer investors the opportunity to speculate on the performance of a sector as a whole. Currency warrants Warrants for global markets 22 Success factors VW and perhaps even Porsche stocks. Basket warrants therefore give investors the chance to speculate on sector trends or the performance of a particular equity market rather than on single stocks. Investors who forecast a flourishing automotive industry and yet are unsure which stocks are going to fare best can buy a basket warrant and benefit from upside across the whole sector. The same applies to the downside, as basket warrants also come in the put variety. Currency warrants A further market segment consists of currency warrants. These derivatives enable investors to speculate on the performance of the euro in relation to foreign currencies. The US dollar is by far the most important currency in this segment, although warrants do exist on the Swiss franc, the Swedish krona, the British pound, the Japanese yen and the Canadian and Australian dollars. In addition, warrants can be bought for Their underlying consists of an equity basket. This basket is, of course, not put together at random; the stocks all have a common denominator in that they may all belong to the same sector or originate from the same country, or both. A suitable example would be a German automotive basket containing BMW, DaimlerChrysler, Success factors 23 Warrant trading and the role of the issuer exchange rate changes between two foreign currencies, such as the US dollar and the Japanese yen. It goes without saying that there are also a large number of puts on offer that can be used to speculate on the weakness of a particular currency or to hedge against currency losses. This can prove vital if you own foreign stocks or are owed a sum of money in a foreign currency. Note: you would buy a euro/US dollar call if you predicted that the euro was going to strengthen against the US-dollar and a euro/US dollar put for the reverse scenario. Warrants for global markets The smallest segment of the options market consists of commodity warrants. The most popular and virtually exclusive underlying assets are gold and silver, measured in troy ounces (31.1035 grams). Investors who predict that the price of gold will shoot up quickly can achieve a far higher return on commodity warrants than gold coins or mine stocks. 24 Success factors Warrants with bonds as their underlying are known as bond warrants. These derivatives can be used to speculate on the downside or upside potential of fixed-income securities and thus also on a change in the general level of interest rates on the capital markets. The German term Zinsoptionsschein (interest warrant), however, is a little misleading as when you buy an equity call, you predict that the share prices are going to rise, whereas when you buy a bond call, you believe that the price of bonds is going to rise and are therefore speculating on a fall and not a rise in interest rates. As bonds are more sensitive to interest rate changes the longer their time to maturity, bond warrant buyers must not only consider the maturity of the warrant but also that of the underlying. This problem does not exist for equity warrants, whose underlying assets do not have a limited lifespan. The principal underlying assets of bond warrants traded in Germany are Bunds and US Treasury Bonds. Key conditions for warrant trading Key conditions for warrant trading Provision of liquidity Far from being a recent invention of the Internet generation, options date back to the 17th century, when, during the tulip mania that swept through Holland, they granted bearers the right to buy tulip bulbs. Calls and puts were also being used as early as the 19th century by farmers on the Chicago Board of Trade to hedge against – and, of course, speculate on – the price fluctuations of agricultural goods. The enormous surge in warrant trading, however, particularly in Germany, came not so long ago. During the ‘80s, it was still easy to keep tabs on the prices of German warrants, virtually all of them being of the Sources of information “traditional” variety, i.e. appearing as a constituent of a warrantlinked bond issued by companies as part of a conditional capital increase. Soon, however, came the first of the covered warrants, which are now the most common type of warrant issued on the market. “Covered” means that the issuer is not the company upon whose stock the warrant is based. Over subsequent years, this range of listed warrants grew to incorporate, alongside basket warrants and exotic constructions, calls and puts on an ever increasing array of underlying assets. Warrant trading has continued to gain in significance ever since and as yet has shown no signs of ebbing. Success factors 25 Issuers now compete fiercely with each other to bring out the best product. When a series of warrants expires or there is a large difference between the price of the underlying asset and the strike of the listed warrants, new warrants are issued at the drop of a hat. For every new warrant issued, an offering circular must be published detailing its terms and conditions. Before the warrant can be issued, the offering circular must be checked by the Zulassungsstelle (Admission Board) of the German Stock Exchange or else the Bundesanstalt für Finanzdienstleistungsaufsicht (Federal Financial Superisory Authority) to ensure it meets the legal requirements. A notice is also issued in which the issuer discloses that the offering circular has been deposited with the relevant authorities. Once the warrant has been given a Wertpapier-Kennnummer or WKN (German security identification number) and the issuer has filed an application with the stock exchange on which the new security is to be listed, there is nothing standing in the way of the launch. 26 Success factors The offering circular outlines the exact terms and conditions of the warrant, i.e. such features as maturity, exercise ratio and type of option (European or American). Other provisions govern cases in which the underlying asset may be subject to changing circumstances (merger, capital increase) during the lifetime of the warrant. Putting the formalities to one side, issuers therefore have to fulfil various criteria in order to remain competitive. First, they have to launch products that will attract investors, demand ultimately determining supply on the warrant market. Secondly, they have to react faster than their peers to new market conditions. When a share price collapses, for example, they should be the first to issue new warrants with strike prices set at up-to-date price levels. As is the case for many other financial instruments, warrants enjoy an active market in which, depending on the price of the underlying, a price is determined for every warrant. These derivatives are mostly launched or listed on a securities exchange, where brokers are poised to bring demand and supply into equilibrium, determining spot prices for the warrants at the close of trading or, in the case of variable-price trading, continually throughout the session. Provision of liquidity In many cases, the liquidity from orders placed by investors on the exchange would not be sufficient for individual warrants. As the majority of investors is usually either on the buy-side or the sellside, demand and supply would therefore not reach equilibrium without some kind of intervention. Another reason why in some segments it would not always be possible to bring demand and supply into equilibrium immediately is that warrants are spread out over the market. An active marketmaking approach is therefore always adopted when issuing warrants on the stock exchange. The buying and selling of warrants is, in principle, no more complicated than trading in other securities, such as equities or bonds. Banks, however, are now subject to legislation requiring them to inform customers interested in warrants and other futures and options transactions of the associated risks. These risks are now detailed in a document entitled “Wichtige Informationen über Verlustrisiken bei Börsentermingeschäften” (Key information on the risk exposure associated with listed options and futures transactions). Investors must provide written confirmation that they have read and understood the contents of this document on a regular basis – i.e. every two years. Besides conforming to the legal requirements, anyone interested in playing the warrants market should also ensure, on a personal level, that they have gained some experience of trading in equities, bonds, funds or certificates. Success factors 27 Strategies As investors are only advised to invest in warrants using capital which, in the worst case scenario, they could afford to lose without getting into financial difficulty, a secure financial background is a prerequisite. Investors have to keep abreast of the latest market developments in order to be able to react appropriately. Moreover, many empirical studies have shown that speculating on the stock exchange is only advisable for people who have the time and energy to manage such an investment. So, if you are currently snowed under at work or have personal issues requiring all your energy, you should perhaps put any warrant trading aside until you have less on your agenda. 28 Success factors Sources of information 90/10 strategy Warrant owners are more reliant on up-to-date information than equity or bond investors, for example. Electronic media, especially Teletext or the Internet, are a good source of free information. We would recommend the Internet services offered by discount brokers and the German stock exchanges. By entering the relevant WKN, you can obtain current prices and sometimes even the indicators for warrants. Your first port of call for warrants of Deutsche Bank AG should, of course, be our website at: www.db-xm.com. Long Call Long Put Hedging Depending particularly on an investor’s expectations and objectives, warrants can be used as part of a wide range of investment strategies. They can serve very conservative purposes, such as the hedging of existing securities portfolios, or they can be used aggressively to speculate on the upside or downside of the underlying asset. A conservative securities portfolio could even be given something of a boost by investing a percentage of the capital in warrants. 90/10 strategy Indeed, anyone interested in bumping up their portfolio could adopt the 90/10 strategy, which is based on a portfolio combining both fixed-income securities and warrants. The ratio of fixedincome securities to warrants is 90 percent to 10 percent. The idea behind this strategy is that the interest income on bonds held in the portfolio must be high enough to offset any total loss made on the warrants. An investor with Success factors 29 ¤100,000 in disposable capital, for example, could invest ¤90,000 in Bunds with a two-year maturity and yielding 5.5 percent. Upon maturity, when these government bonds are redeemed, they would yield a total of 11 percent, or ¤9,900. At the end of the two years, the investor would therefore have ¤99,900 regardless of whether or not the warrants were a total flop. However, if the warrants were also to generate attractive price gains, the total performance of the portfolio would be far greater than if the investor had simply invested the whole ¤100,000 in fixedincome securities. The feasibility of this strategy does, of course, depend on the general interest rate level, i.e. the higher the risk-free return on investment grade bonds, the more worthwhile the strategy. Long Call The most renowned strategy used on the warrant markets involves purchasing call warrants (calls) and is known in the trade as a “long call”. As such, the investor speculates on the price of the underlying rising until the expiry date of the warrant. This strategy only bears fruit if the break-even point is achieved. The price of the underlying must rise to more than 30 Success factors the sum of the strike price plus the warrant price multiplied by the exercise ratio at the time of purchase. Transaction costs are not included. Long Put The opposite strategy, involving the purchase of put warrants (puts), is called a “long put”. Here, the investor believes that the price of the underlying is going to fall dramatically. The break-even point is achieved when the price of the underlying is less than the strike price minus the warrant price at the time of purchase, multiplied by the exercise ratio. Say, for example, you buy a put on a share with a strike price of ¤100 and an exercise ratio of 1.0. Your warrant costs you ¤10 and so the breakeven point lies at ¤90. If the share price falls even further by the time your option expires, you will make a profit. Transactions costs are also not included. Hedging Warrants can also serve very conservative purposes, such as the hedging of securities portfolios against any looming downside. Investors with a large equity exposure, for example, and who expect prices to fall, could think about selling their positions. This, however, may not be advisable for tax or other reasons, including the high transaction costs involved in the sale and perhaps the repurchase of the shares at a later date. Ultimately, however, there is no need to sell if the investors buy puts, effectively “insuring” themselves against any downside. The theory behind this strategy is that if share prices fall, the value of the options will rise, thereby cancelling out any loss in value. This hedging strategy, as with any insurance, nevertheless comes at a price, namely the purchase price of the puts, which can be seen as a kind of insurance premium. If the downside fails to materialise, the premium will be lost but investors can put their minds at rest. In this instance, a distinction should be made between a static and a dynamic hedge. The static hedge is better suited as a 100% safeguard on the expiry date of the warrant, the dynamic variety for the time period prior to expiry. For the former, a single calculation of what type of as well as how many puts are needed to hedge the portfolio is made at a specific point in time. The number remains the same, hence the term “static”. For dynamic hedges, on the other hand, the put position is regularly adjusted depending on the performance of the equity portfolio. The position is therefore considered “dynamic”. Whereas professionals in this field, such as fund and asset managers, tend to prefer the dynamic variety, static hedges are often sufficient to meet the needs of the private investor, especially as the constant adjustments would entail high transaction costs. A portfolio is the easiest to hedge if it contains highly capitalised stocks for which puts are readily available, or if it almost mirrors a particular index for which an equally large amount of puts exist. In the above cases, investors can use warrants to hedge either each individual position or the entire portfolio. The more valuable the assets in the portfolio, the higher the “insurance premium” will be. Another factor influencing the premium is the extent of desired “coverage”, e.g. whether investors want “all risk” or limited insurance, whereby they would bear a portion of any loss incurred. Investors wanting to hedge portfolios that more or less mirror the DAX® can act as follows. Let us assume that the DAX® is currently at 3,000 points and that investors fear it will nose-dive to Success factors 31 the 2,000 mark. By acquiring a sufficient number of puts with a strike price of 3,000 points, they are fully insured, as it were. This method of hedging, however, does not come cheap. Puts with a strike price of 2,800 points and identical maturities are significantly less expensive. Investors buying the cheaper warrants would nevertheless have to bear a portion of the losses were the index to shed those 1,000 points. The insurance cover would only kick in if the DAX® fell below the 2,800 mark. The region between 2,800 and 3,000 points therefore corresponds to the aforementioned portion borne by the investors. Of course, investors may, at a ratio of 50/50, also acquire warrants with a strike price of 2,800 and 3,000 points, as well as opt to bear an even higher portion of incurred losses or, according to their requirements, combine any number of possibilities. The decision is not an easy one and must be considered carefully in each individual case. When opting for dynamic hedges, the best way of calculating how many options are required is via the delta, i.e. the sensitivity of a warrant to changes in the price of the underlying. In the case of puts, the percentage delta has a minus sign before it. If the put has a delta of –50 (–25), two (four) puts are needed to hedge the underlying share because the put only responds at a ratio of 0.5 (0.25) to changes in share price. Static hedge Portfolio value: DAX®: Hedge: Strike price: Maturity: Exercise ratio: Price: Portfolio value: DAX®: Hedge: Strike price: Maturity: Exercise ratio: Delta: Price: ¤300,000 3,000 points put warrant 3,000 points 1 year 1:100 ¤3.01 1st step: Determine the portfolio ratio Portfolio value / DAX® 300,000 / 3,000 = 100 Scenario: Changes in the DAX® have the following impact upon maturity: Put position –100 –30,100 –30,100 –30,100 3,000 points put warrant 3,000 points 1 year 1:100 –0.49 ¤3.01 2nd step: number of required put warrants Portfolio ratio x exercise ratio ÷ delta 100 x 100 / delta = 20,408 put warrants According to this calculation, the hedge will cost ¤30,100. This represents 10.03 percent of the value of the portfolio. Equity portfolio –10% –30,000 ±0% ±0 +10.03% +30,100 +20% +60,000 ¤300,000 1st step: Determine portfolio ratio Portfolio value / DAX® 300,000 / 3,000 = 100 2nd step: number of required put warrants Portfolio ratio x exercise ratio 100 x 100 = 10,000 put warrants DAX® 32 Success factors Dynamic hedge Total portfolio –30,100 –30,100 ±0 +29,900 According to this calculation, the hedge will cost ¤61,428.57. This represents 20.48 percent of the value of the portfolio. This same method can be applied to hedging based on equity warrants. In order to determine the required number of puts, the value of the equity position to be hedged is divided by the share price, thereby taking the delta of warrants into account. While the number of warrants for static hedges remains the same until the expiry date, the number of puts is constantly changed in the case of dynamic hedges. The static hedge is therefore used to safeguard a portfolio at a specific point in time, whereas the dynamic variety is used for a specific period of time. If the delta remains the same, warrants will be bought or sold to consistently maintain a delta-neutral position. Success factors 33 Finding the right warrant Toss-up between risk appetite and indicator analyses Toss-up between risk appetite and indicator analyses Market-smoothing service All investment decisions are centred around certain principles, such as investment type and the investor’s risk appetite, i.e. conservative/riskaverse or more aggressive/risktolerant. The investment objective is also important: is the investment for speculative purposes, for reducing risk exposure or hedging, or does the investor want to make specific adjustments to risk/return profiles with a combination of financial instruments? Long trading hours: an important criterion Market-smoothing service Compared to direct investments, warrants vary on a qualitative as well as quantitative level. In order to make a well-balanced investment decision, investors must have access to reliable and up-to-date information as well as be fully aware of the risk/return profile of these investments. Knowledge and understanding of all parameters affecting the performance of warrants is therefore essential. The selection process can be broken down into three phases: the information phase, the decision phase and finally the control phase. At first, detailed information on 34 Success factors the market environment as well as the product features and respective underlying assets must be obtained. A basic prerequisite for investing in warrants is a very clear idea on how the price of the underlying is going to develop as well as the period of time in which this price movement is going to occur. In the second phase, a decision should then be made on the maximum risk tolerance of the investor, the amount of capital to be invested and which warrant features would best suit the investor’s investment objectives. Other factors include the quality of the information provided by the issuer as well as marketsmoothing and other services. The third phase ultimately begins when the warrants are acquired and includes all measures undertaken up to the exercise or sale of the position. During this phase, the investor mainly measures the performance of the warrants, monitors their prices and controls the investment. The aforementioned key features of a warrant – call or put, maturity and strike price – are selected according to investor expectations, such as the direction and extent of price movements in the underlying as well as the investment horizon and the choice of strike price in relation to the prevailing market price. Speculative investors would choose a short maturity as well as a strike price that is either “at the money” or slightly “out of the money”. The more conservative investor would opt for longer maturities and a strike price “in the money”. When investing in warrants, there is little point in focusing on individual indicators. A combination of indicators will provide a more overall picture, which is vital. Investors who predict a sudden and sharp change in prices are going to opt for different warrants than investors who wish to speculate on slow but steady price movements. Something to watch out for, in any case, is that warrants have sufficient time to maturity, i.e. warrants with a delta of less than 0.15 for calls and –0.15 for puts should be avoided. The smaller the delta, the greater the influence of implied volatility. If investors have a choice of two otherwise identical warrants, they should opt for the one with the lowest implied volatility due to its price advantage. They should also watch out for the spread. Due to the bid-offer spread between the purchase and sale of warrants, the price of the warrant must rise by at least the spread amount in order to ensure a loss-free investment. Investors, however, should not be fooled by what look like narrow spreads. A one-cent spread for a warrant with an exercise ratio of 100:1 means a one-euro spread for the underlying. By contrast, a two-cent spread for a warrant with an exercise ratio of 10:1 means an underlying spread of a mere 20 cents. Investors should therefore look at the homogenised spread. Long trading hours: an important criterion Finally, various services provided by the issuer as well as the marketability of warrants are also significant factors. When considering warrants on underlying assets issued in the USA, investors should remember these derivatives can be traded until 22:00. Success factors 35 FAQs What is the difference between a warrant and an option? What is the difference between a warrant and an option? Why are there so many different warrants on certain financial assets, such as the DAX®, the US dollar or a number of single stocks? Warrants, as opposed to options, represent certificated option rights. Both grant the right, but not the obligation, to buy or sell a financial asset at specific conditions. All warrants have a WKN and when issued, are accompanied by an offering circular that specifies their terms and conditions (maturity, exercise ratio etc.). Warrants are normally issued by banks, whereas options are usually made available by and only traded on futures and options exchanges. Why are there so many warrants available on certain stocks and not one single warrant on others? Does the large number of warrants available not dampen their individual liquidity? Why are there so many different warrants on certain financial assets, such as the DAX®, the US dollar or a number of single stocks? Fierce competition exists between the 30 or so warrant issuers in Germany, which explains the large number of these derivatives available on the favourite underlying assets of investors. Pronounced equity market trends can lead to large gaps between the prices of these underlying assets and the strike prices of the existing listed warrants. Issuers respond by creating new warrants with more up-to-date strikes. The increasing 36 Success factors number of “exotic” warrants has also meant that at the beginning of 2003, a total of 30,000 warrants were traded on the German stock exchanges. Why are there so many warrants available on certain stocks and not one single warrant on others? This is an example of where demand determines supply. Issuers mainly launch warrants for which they can be sure of a high level of investor demand. Furthermore, warrants are generally not issued on the shares of companies that have not officially given their authorisation. Does the large number of warrants available not dampen their individual liquidity? No, because issuers always guarantee a liquid market for the warrants they launch. They constantly quote bid and ask prices at which their warrants can be bought or sold (OTC or “off-exchange” trading). Therefore, as opposed to low-trading shares, you do not have to worry that your warrant orders will not be settled due to a lack of liquidity. What is the difference between OTC (off-exchange) and “normal” (on-exchange) warrant trading? What is the difference between OTC (off-exchange) and “normal” (on-exchange) warrant trading? Does the warrant issuer lose out if the investor makes a profit on the warrant? A trade is effected on the stock exchange when an investor finds another investor who is willing to act as counterparty, i.e. willing to accept the former investor’s bid or offer at a specific price. If this does not occur, the broker will approach the issuer. OTC or off-exchange trading involves investors dealing directly with a warrant issuer via their bank. The issuer acts as a market-maker, from or to whom investors can buy or sell warrants at any time. There is also a difference in trading hours: on-exchange trading takes place between 9:00 and 20:00, off-exchange trading for longer. Deutsche Bank AG quotes prices for its products between 8:00 and 22:00. Companies sometimes undertake capital increases, mergers or change the nominal value of their shares. What happens to the warrants issued on such underlying assets? Companies sometimes undertake capital increases, mergers or change the nominal value of their shares. What happens to the warrants issued on such underlying assets? In the above cases, the terms and conditions of the warrants are adjusted accordingly. These adjustments are specified in the offering circular accompanying each warrant and ensure that the mentioned measures do not place the investor at any disadvantage. The investor is placed in the same economic position as before the measures. Does the warrant issuer lose out if the investor makes a profit on the warrant? No, because issuers hedge their positions and therefore do not speculate contrary to the investor. This is also the reason why there are hardly any warrants issued on illiquid stocks, which cannot be sufficiently hedged. Success factors 37 Tax treatment of warrants held as private assets Sale of warrants Sale of warrants Settlement at maturity As is the case with other securities, the profits or losses arising from the sale of warrants are taxable, under certain circumstances, as income from the disposal of private assets (Einkünfte aus privaten Veräußerungsgeschäften) (formerly known as speculative gains), but only if the period between purchase and sale is less than one year. By the same token, the proceeds from the sale of warrants held for longer than one year are tax free. If the entire proceeds from the disposal of private assets during a single calendar year are less than ¤512, these are also tax free (exemption limit). If this limit is exceeded, the entire proceeds are subject to tax. This twelve-month cut-off point can be particularly disadvantageous for warrant bearers. Investors who are interested in tax-free profits, for example, may only opt for warrants with more than a one-year maturity at the time of purchase, which limits their choice considerably. It is also very difficult to predict trends that will last for a whole year. The investor is therefore often faced with a dilemma: either to realise gains and then pay tax on them or hold 38 Appendix the warrants beyond the one-year cut-off – ultimately running the risk of those gains disappearing. A stock exchange lore says that a taxable profit is better than a taxfree loss. The tax treatment of realised losses arising from the sale of warrants is as follows. Losses are tax deductible if they are incurred during the one-year cut-off period, yet they may only be offset against taxable income from the sale of other private assets (e.g. shares). These losses are primarily offset against income realised during the same year. If this is not possible, the losses can also be carried back to the previous year and then carried forward to future calendar years for an indefinite period. This guarantees that losses realised during the one-year cut-off period can be used to lower an investor’s tax liability instead of just being written off – as was previously the case. Investors who notice their warrants are in negative territory just before the end of this twelvemonth period could consider selling them and – provided they are unable to offset them against income from the sale of private assets from the same calendar year – either carrying the incurred loss back to the previous year or, upon request to the tax authorities, forward to the following year(s). Investors who realise this kind of income in 2001 and then suffer corresponding losses in 2002 may carry back those losses in their 2003 income tax assessment. The income from the disposal of private assets that was taxed in 2001 would then be reduced by the amount of the loss carryback and the remitted tax paid back to the investors. If investors decide in favour of a loss carryforward, proceeds from the sale of private assets during the following year(s) are only taxable if they exceed the loss carryforward. The half-income procedure (Halbeinkünfteverfahren), whereby private investors are only liable to tax on 50% of capital gains and dividends from shares, does not apply to warrants, even if they grant subscription rights. Warrants cannot be placed on a par with shares as they do not represent any shareholder rights. Settlement at maturity Cash settlement Nowadays, most warrants are no longer settled by means of physical delivery of the underlying; instead, their terms and conditions provide for cash settlement. If the cash settlement takes place within one year of purchasing the warrant, a disposal of private assets exists pursuant to § 23 Sub-section 1 No. 4 EStG (German Income Tax Act). The gain or loss on disposal then equals the difference between the cash amount and the acquisition costs (plus ancillary costs such as transaction costs) of the warrant. Subscription to shares The exercise of a warrant and the ensuing subscription to shares initially have no tax implications. As of the exercise date, however, the acquired shares are subject to a new cut-off period. This means that investors have to hold the securities in their portfolios for more than twelve months in order to realise any capital gains tax free. The acquisition costs of the shares consist of the strike price as well as the acquisition and ancillary costs of the warrant. According to the tax authorities, losses arising when warrants expire worthless (cash settlement or subscription to shares) are not tax deductible. Instead, investors are advised to sell these warrants within the one-year cut-off period and thereby make use of the tax loss in their income tax assessment. Appendix 39 Internet service We have set up a user-friendly service centre for you at the following Internet address: www.db-xm.com. This website Recommended literature contains a clear and comprehensive list of available warrants, providing you with information at the touch of a button. Fugger, H., und Koch, J.: Mehr Geld verdienen mit Optionsscheinen. München 1999; ISBN: 3-932114-08-6 Hull, J.: Options, Futures and Other Derivatives. Upper Saddle River 2000; ISBN: 0130224448 Klotz, A., und Philipp, J.: Die Welt der Optionsscheine. München 2000; ISBN: 3-932114-33-7 Finding the right warrant for you: Function 1: If you already know the WKN of a specific warrant, enter this in the “Schnellsuche (Quick search)” box and you will be able to view the features of the warrants. Function 2: If you are looking for a warrant on a particular stock, simply select “Produktsuche (Product search)” before entering the type of stock in “Produktart (Type of product)” and the name of the stock in “Name des Basiswerts (Name of underlying)”. Function 3: If you would like to get an overview of the warrants offered by Deutsche Bank, simply 40 Appendix select “Produktsuche (Product search)”, enter the desired type of warrant and a list of all our available warrants will appear. Should you have any further questions, you may, of course, also contact us directly. Contact addresses can be found on the back page of this brochure. For more information on warrants, please consult the brochure entitled “Basisinformationen über Vermögensanlagen in Wertpapieren” (Basic information on securities investments) as well as the various term sheets available on the website given above. Natenberg, S.: Option Volatility & Pricing: Advanced Trading Strategies and Techniques. NYC 1994; ISBN: 155738486X Schaeffer, B.: Millionen mit Optionen. München 1999; ISBN: 3-932114-15-9 Schwanfelder, W.: Optionsscheine für Einsteiger. Franfurt 1998; ISBN: 3-593-36060-8 Uszczapowski, I.: Optionen und Futures verstehen. München 1999; ISBN: 3-423-05808-0 Appendix 41 42 Appendix Warrants glossary Product information Telephone info line E-mail Internet Magazine +49 (69) 9 10-3 88 07 [email protected] www.db-xm.com X-press (published every month) Free of charge Price information Teletext n-tv Text 770 Reuters DBMENU Telephone price line 01805/950955 This brochure has been printed on environmentally friendly paper. Address Deutsche Bank AG X-markets-Team Große Gallusstraße 10–14 60272 Frankfurt am Main Deutsche Bank AG D-60262 Frankfurt am Main Key data for sample calculations A American option – At the money The sample calculations used in the following definitions are based on the following key data for shares of the fictitious Deutsche Automobil AG. Key data used for the sample calculations Strike price: Price of the underlying: Time to maturity: Warrant price: ¤0.50 30.5% Delta: 0.546 Vega: 0.2 Gamma: Ask price The price demanded for a financial instrument. Issuers or brokers sell at this price. At the money When the price of the underlying is equivalent or very close to the strike price. See also >out of the money, >in the money ¤43 exactly one year 1 to 10 Theta (weekly): Warrants that may be exercised at any time prior to expiry; also known as American-style options. ¤45 Exercise ratio: Implied volatility: American option –1.12% Potential price floors Type of warrant in the money at the money 0.3 out of the money 2 Intrinsic value Call Put strike price < underlying strike price > underlying >0 strike price = underlying strike price = underlying =0 strike price > underlying strike price < underlying =0 3 B–C C–E Basket – Cash settlement Current leverage – Expected volatility Basket An “equity basket” comprising of several single stocks and used as the underlying of basket warrants. Bid price The price offered for a financial instrument. On the warrants market, this is the price at which issuers or brokers offer to buy a warrant and at which investors can sell it. Break-even point Current leverage Leverage shows the percentage increase or decrease in the price of the warrant if the share price rises or falls by 1 percent. This, however, assumes a constant premium. See also >omega. Delta An indicator that shows absolute changes in the price of the warrant if the price of the underlying changes. If the price of a Deutsche Automobil AG share rises from ¤43 to ¤44, the price of the warrant will increase from ¤0.50 to ¤0.56. Calculation: delta (0.546) x exercise ratio (0.1) x movement in the share price. If the share price were to fall by ¤1 euro, the warrant would lose ¤0.055 in value. In the case of put warrants, the delta is negative as the price of a put rises if the price of the underlying falls. With call warrants, the delta is therefore between 0 and 1; with put warrants, it is between 0 and –1. Indicates the price level above (below) which the investor will make a profit in the case of a call (put). Transaction costs are not taken into account. Call: warrant price exercise ratio + strike price Example: ¤0.50 + ¤45 = ¤50 0.1 Put: strike price – Example: ¤0.50 ¤45 – 0.1 = ¤40 Call See >call warrant. Call warrant (call) Warrant granting the right to buy the underlying at the strike price according to a certain exercise ratio prior to or on the agreed expiry date, or to receive payment of a differential amount. A call warrant is often simply referred to as a call. Cash settlement Instead of delivery of the underlying, a cash settlement may also be agreed in the terms and conditions of the warrant. If this is the case, the difference between the current price of the underlying and the strike price (adjusted for the exercise ratio) is paid out. This is standard practice. 4 European option Warrants that may only be exercised on the expiry date; also known as European-style options. Exercise Use of the right granted by the option. This requires written notice of intent. Exercise ratio Indicates the number of options per warrant and specifies the amount of the underlying that the owner of a single warrant is entitled to buy or sell. Expected volatility The expected price fluctuation range of a warrant’s underlying within a specified future time period, which usually corresponds to the option's time to maturity. warrant price exercise ratio 5 Gamma G–I I–L Gamma – Implied volatility In the money – Leverage Indicator that shows changes in the delta following price movements of the underlying. If the Deutsche Automobil AG share price moves by a currency unit, the delta also moves. A Gamma of 0.03 (Gamma x exercise ratio) means the delta of the call will increase from 0.546 to 0.576 if the share price rises to ¤44. If the share price falls to ¤42, the delta will fall to 0.516. It is important to note that, in the case of put warrants, the delta increases if the price of the underlying decreases and the delta falls if the price of the underlying rises. Hedging Historical volatility Implied volatility Describes the situation when a warrant has an intrinsic value i.e. in the case of calls, the current price of the underlying is above, and in the case of puts, below the strike price. See also >at the money, >out of the money Intrinsic value The actual value of an option when exercised at a particular point in time – also known as parity. This equals the (positive) difference between the strike price and the current price of the underlying, taking into account the exercise ratio. Intrinsic value of call = (price of the underlying – strike price) x exercise ratio Limits the risk involved in a securities transaction by means of a second countertransaction. For example, in the case of put warrants, hedges may be used to insure against price losses in a securities portfolio. Example: Example: Volatility as determined on the basis of prices of options and warrants traded at a particular time on the market. Volatility = volatility per trading day x (in index points) 公僒僒僒僒 number of trading days Example: 僒 僒 = 800 points 50 x 公256 In the light of these expectations, future volatility is calculated to be 800 points on an annual basis or, assuming the basic value (3,000 points), 26.6 percent. This calculation is based on the assumption of 256 trading days per year. (¤43 – ¤45) x 0.1 = ¤0* Intrinsic value of put = (strike price – price of the underlying) x exercise ratio Price fluctuation range of a warrant's underlying during a specified period in the past. Example of volatility: Let us assume that the DAX is at 3,000 points, and you anticipate a daily fluctuation range of 50 points i.e. 1.6 percent. You can now calculate the expected volatility of your options for any time period using the following formula: 6 In the money (¤45 – ¤43) x 0.1 = ¤0.2 *Note: the intrinsic value of an option can never be negative. Issuer Institution that issues the warrant and serves as debtor for the option it represents – e.g. Deutsche Bank AG. Leverage Leverage shows the extent to which a warrant moves in line with its underlying. The current leverage of a warrant is calculated by dividing the price of the underlying by the price of the warrant (adjusted for the exercise ratio). >current leverage, >omega. Leverage: price of the underlying x exercise ratio warrant price Example: ¤43 x 0.1 = 8.60 ¤0.50 7 L–P P Long call – Physical delivery Premium – Premium (annual) Long call The purchase of a call warrant in order to speculate on a rise in the price of the underlying. Long put The purchase of a put warrant in order to speculate on a fall in the price of the underlying. Maturity Omega Premium Call: The “lifetime” of a warrant as determined in the terms and conditions. The option expires upon maturity. Omega – also referred to as elasticity – is regarded as “refined” leverage as it takes into account the delta. The result is often described as elasticity or gearing. The omega indicates the percentage change in the price of the warrant relative to a one percent change in the share price. Example: 8.6 x (0.546 x 0.1) = 0.47% If, therefore, the share price rises by 1 percent from ¤43 to ¤43.43, the warrant price will increase by 0.47% to ¤0.502. Describes the situation when a warrant has no intrinsic value i.e. in the case of calls, the current price of the underlying is below, and in the case of puts, above the strike price. See also >at the money, >in the money Parity Synonym for the >intrinsic value of a warrant. Parity-related indicators Generic term for warrant indicators that are based on the intrinsic value (e.g. break-even point, premium). Physical delivery If stipulated in the option's terms and conditions, the call owner's portfolio is credited with the underlying at the agreed strike price upon exercising the option. The owner of a put is entitled to sell the underlying in line with the agreed terms and conditions. A cash settlement may be agreed instead of physical delivery. 8 warrant price exercise ratio + strike price – price of the underlying Example: ¤0.50 + ¤45 – ¤43 = ¤7 0.1 Put: warrant price exercise ratio + price of the underlying – strike price Example: ¤0.50 + ¤43 – ¤45 = ¤3 0.1 Omega = leverage x (delta x exercise ratio) Out of the money The amount by which the cost of acquiring the underlying by exercising the warrant exceeds the cost of buying the underlying directly. Premium (annual) The time to maturity of the warrant also affects the premium level. Premiums are therefore compared on an annual basis. The formula for this is quite simple: premium (percentage) = annual premium time to maturity in years Example for a call warrant: 16.28% = 16.28% p.a. 1 year Example for a put warrant: 6.98% = 6.98% p.a. 1 year 9 Premium (percentage) P R–T Premium (percentage) – Put warrant (put) Rho – Theta In the case of warrants, the calculation formula for the percentage premium is as follows: Call: ( warrant price + strike price – price of the underlying exercise ratio x 100 price of the underlying ) Example: ¤0.50 + ¤45 – ¤43 0.1 x 100 = 16.28% ¤43 ( Put: ( ) warrant price + price of the underlying – strike price exercise ratio x 100 price of the underlying ) Example: ¤0.50 + ¤43 – ¤45 0.1 x 100 = 6.98% ¤43 ( ) Put See >put warrant Put warrant (put) Warrant granting the right to sell the underlying at the strike price according to a certain exercise ratio prior to or on the agreed expiry date. It may also entitle the owner to receive payment of an appropriate differential amount. A put warrant is often simply referred to as a put. 10 Rho Indicator which shows the influence of changes in general interest-rate levels on the price of warrants. Spread The difference between the bid and ask prices. The spread can be specified as a percentage or in currency units. Note: in order to compare the spreads of warrants, they must be homogenised i.e. they must be based on the same exercise ratio. Straddle Simultaneous purchase of calls and puts on the same underlying as well as identical strike prices and maturities. The aim is to benefit from sudden price changes and/or an increase in volatility. Strike price The price at which the financial instrument underlying the option may be bought (calls) or sold (puts) as well as the price which is used to calculate the cash settlement, where applicable. Theta Indicator which shows the influence of time on the price of warrants. It indicates the extent to which the warrant price changes on a daily basis as the time to maturity decreases. If, in the space of a week (i.e. 7 days, not 5 working days), the warrant loses 1.12 percent or ¤0.006 in value, its price will fall from ¤0.50 to ¤0.49. 11 Time value T U–W Time value Underlying (underlying asset) – Warrant The time value is the difference between the current warrant price and its intrinsic value. The time value is to be interpreted as the consideration paid for the advantages (leverage effect) that the warrant buyer has over the direct investor. It is based on the liquidity advantage as the warrant buyer has to pay less than the buyer of the underlying. Underlying (underlying asset) The financial instrument underlying the warrant e.g. a share or share index. Often also referred to as the underlying asset. Vega Indicator which shows how sensitive warrant prices are to changes in volatility. The price of the warrant includes an implied volatility of 30.5 percent. If the implied volatility increases by 1 percent to 31.5 percent, the warrant will gain ¤0.02 in value (Vega x exercise ratio) and will increase to ¤0.52. Similarly, the warrant will lose ¤0.02 if the implied volatility falls by one percentage point. Volatility Volatility measures the fluctuation range of the underlying's price within a specified time period e.g. a year. See also >historical volatility, >implied volatility. Warrant International common naming for securitised options. Time value = price of the warrant – the warrant's intrinsic value Example for a call warrant: ¤0.50 – ¤0 = ¤0.50* * The price of the call in the example comprises only time value. Example for a put warrant: ¤0.50 – ¤0.20 = ¤0.30 Value of the time premium Erosion of time value as the warrant approaches maturity 5 4 3 2 1 0 90 days 60 days 30 days Time to maturity 0 The chart shows the erosion of time value as we approach maturity in case the warrant has no intrinsic value. 12 13 The sponsors of the indices mentioned in this brochure have no relationship to the products on offer other than the licensing of the indices. They do not endorse, recommend or promote them. All trademarks for the aforementioned indices are owned by the respective index sponsor. 14