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Warrants with Knock-Out: How they work

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Vontobel Markets
23 Oct 2023 | 5 minutes to read
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Warrants with Knock-Out provide investors with a leveraged participation in the performance of a financial asset. The leverage effect arises from the fact that less capital is required compared to a direct investment. Investors can speculate on both rising and falling prices with less capital invested. Various asset classes such as stocks, indices, commodities, precious metals, interest instruments, or currency pairs are available.

How Warrants with Knock-Out work

Warrants with Knock-Out replicate the performance of an underlying asset disproportionally due to their leverage effect. Compared to a direct investment in the underlying asset, Warrants with Knock-Out require less capital, creating a leverage effect. Investors only finance a portion of the underlying asset, while the issuer covers the rest. The issuer’s financing part leads to financing cost. As a result, investors can participate in the performance of the underlying asset while needing only a fraction of the capital required for a direct investment.

Warrants with Knock-Out offer transparency as their intrinsic value can be derived directly from the underlying asset. The intrinsic value of a Warrant with Knock-Out is essentially determined by the difference between the current price of the underlying asset and the Knock-Out level (Strike) of the product, taking the product ratio into account.

Higher leverage occurs when the difference between the current price of the underlying asset and the Strike decreases. A smaller difference also implies a higher level of risk, as the Knock-Out level moves closer.

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Warrants with and without fixed maturities:

Investors can use Call products to speculate on rising prices and Put products to speculate on falling prices. Warrants with Knock-Out are available with fixed maturity or without fixed maturity (Open-End). For Warrants with Knock-Out, a premium may be charged in addition to the intrinsic value. In products with fixed maturities, this premium includes financing costs and risk premiums. For Open-End products, the premium only considers the risk premium, as the financing costs are incorporated into the daily adjustment of the Strike.

Special features of Warrants with Knock-Out

Compared to traditional derivatives such as Warrants and Futures, Warrants with Knock-Out offer some distinctive features. Unlike traditional Warrants, volatility only plays a minor role. Additionally, Warrants with Knock-Out do not have a time value, unlike regular Warrants. Compared to Futures, the maximum loss is limited to the invested capital, eliminating the possibility of a margin call.

Risks associated with this product category must also be mentioned. The leverage works in both directions, leading to potentially amplified gains but also corresponding losses. Furthermore, Warrants with Knock-Out are equipped with a Knock-Out level. If the underlying asset reaches this level, the product expires and is immediately worthless. In such a scenario, an investor incurs a total loss of the invested capital.

Costs of Warrants with Knock-Out

To achieve the leverage effect in the product, the Knock-Out level (Strike) needs to be financed, leading to costs. These costs are considered in the form of financing costs, comprising the money market interest rate (reference interest rate), and a financing margin (financing spread). For products with fixed maturities, these costs are added to the price as a premium. For products without fixed maturities (Open-End), the costs are reflected through daily adjustments of the Knock-Out level (Strike).

Broad range of underlying assets

Broad range of underlying assets

Warrants with Knock-Out offer investors a diverse universe of investable asset classes. This product category allows for an amplified participation in stocks, indices, commodities, precious metals, interest instruments, and currency pairs.

Hedging existing positions

Warrants with Knock-Out can also be used to hedge existing positions. Investors can protect their existing portfolios from potential losses. For instance, an existing (long) portfolio, can be complemented with an opposing (short) position. The hedge takes effect immediately after the purchase and offsets losses of the portfolio. The capital invested for the hedge is lost when the Knock-Out level is reached.

Pro and Con`s: Warrants with Knock-Out

Advantages of Warrants with Knock-Out

-          Volatility only plays a minor role

-          Less capital invested than direct investment

-          Available for rising (Call) and falling (Put) prices

-          Intrinsic value easily determined

-          Many different asset classes available

Disadvantages of Warrants with Knock-Out

-          Market risk of underlying

-          Leverage effect works in both directions, amplified gains & losses, up to total loss

-          Currency risk if underlying differs from product currency

-          Issuer risk

-          Ordinary termination right for the issuer of Open-End products

FAQ

How does volatility influence a Warrant with Knock-Out?

Changes in the implied volatility of the underlying asset only have a minimal effect on the value of a Warrant with Knock-Out. The pricing is thus transparent and easily comprehensible.

What happens when the Knock-Out Level is reached?

When the price of the underlying asset reaches, falls (Call) or rises above (Put) the Knock-Out level during the observation period, the product immediately expires worthless. The Knock-Out level is continuously monitored starting from the initial fixing date.

A Knock-Out event for a Call Warrant with Knock-Out occurs when the price of the respective underlying asset touches or falls below the current Knock-Out level at any point during the trading hours of the underlying asset on the reference exchange or determining entity (continuous observation). For a Put Warrant with Knock-Out, a Knock-Out event is triggered when the Knock-Out level is reached or if the underlying rises above.

Can Knock-Out Warrants be knocked out outside the product's trading hours?

Here, a distinction must be made between the trading hours of the product and those of the underlying asset. The products are listed and can be bought or sold during regular exchange trading hours. Different trading hours may apply depending on the underlying asset. It is important to note that, for example, currencies can be traded almost continuously, whereas the trading for products on currencies depends on the exchange trading hours. This means a Knock-Out event could occur without the investor being able to sell the product on the exchange. Therefore, investors should inform themselves about the trading hours of the underlying asset before purchasing such products.

A stock pays a dividend. How does a dividend distribution affect an Warrant with Knock-Out Open-End?

The price of a stock is adjusted by the amount of the dividend on the ex-dividend date. Similarly, adjustments are made to a Warrant with Knock-Out.

For a Call product, on the ex-dividend date of a stock, the net dividend is subtracted from the Knock-Out level. The net dividend considers the tax factor of any dividend payment.

For a Put product, the adjustment considers the gross dividend. The exercise price is reduced by the gross dividend.

What does premium mean?

For Warrants with Knock-Out, it is possible that a premium is charged in addition to the intrinsic value. In products with a fixed term, the premium represents financing costs and a risk premium, while in products without a fixed term (Open-End), only the risk premium is considered in the premium.

The risk premium serves to hedge the so-called gap and liquidity risk. Gap risk describes the issuer's risk that the hedging transaction cannot be reversed at the Knock-Out level in the event of a Knock-Out event. Liquidity risk reflects the tradability of the underlying asset.

An important component of a Knock-Out Warrant is the Knock-Out level. Does the Knock-Out level change over time?

To answer this question, a distinction must be made between products with a fixed term and those without a fixed term (Open-End).

The Knock-Out barrier of Knock-Out Warrants with a fixed term is set at issuance and does not change.

For Knock-Out Warrants without a fixed term (Open-End), the Knock-Out barrier is adjusted at the end of each adjustment day. An adjustment day is considered to be any day from Monday to Friday after the initial fixing day. Daily adjustments are made to account for the issuer's financing costs.

In practice, an adjustment of the Knock-Out barrier for Call products means an increase in the Knock-Out barrier, and for Put products, it means a lowering of the Knock-Out barrier.

What happens with a Warrant with Knock-Out based on a futures contract when the underlying future contract expires?

Future contracts have a fixed term. For a product without a fixed term, the underlying asset must be replaced to ensure the continuation of the product.

In the case of a Call Warrant with Knock-Out, the issuer sells the current contract and buys a longer-term contract. This process is also referred to as a "rolling" of futures.

A similar process occurs for a Put Warrant with Knock-Out. The short position of the previous contract is closed through a purchase, and the short position is re-established in the new, longer-term contract.