Boosted leverage

Despite the current market climate, turbo warrants have experienced huge growth since they first appeared in late 2001. In Germany this new market segment has grown strongly since the start of the year, now generating turnover of up to E3.8bn per month (which is up to 90 per cent of current plain vanilla warrants’ market volumes). Turbo bull and turbo bear warrants are issued on both stocks and indices. They allow speculative investors an either bullish or bearish investment in an underlying security with a small capital outlay, thus creating a high gearing effect. However, in contrast to plain vanilla warrants, the price evolution of turbos is determined almost exclusively by movements in the levels of the underlying security, with only a minor influence of implied volatility movements – an attractive feature for investors in markets decreasing in volatility. This also means that the pricing of turbos is easier for the investor to understand and follow. A turbo warrant is “path-dependent”. In other words, at expiry the payoff will not only depend on where the price of the underlying security is on that date, as with a vanilla warrant, but also on the path of the underlying’s price during the life of the turbo. At expiry the payoff will be similar to a vanilla warrant, provided that during the life of the turbo warrant the price of the underlying never trades at the strike price. This extra feature is called a “barrier” and if it is ever reached at any moment over the life of the turbo warrant it will immediately cause the warrant to expire worthless. The barrier is defined at the same level as the strike. The characteristics of turbo warrants have particular consequences for the investor: the deltas (delta indicates the percentage change in the price of the warrant caused by a unit change in the underlying) are close to one and the impact of implied volatility changes is very small. Given the extra risk the investor is taking – the risk that at some point the barrier is reached and the turbo warrant will expire worthless – the value of a turbo warrant will be lower than the value of a similar vanilla warrant. This will often allow the investor a higher sensibility than with call and put warrants, through the lower premium paid. The leverage effect can be seen in the graph, as the turbo curve (red) is much steeper than the curve of the plain vanilla call. This leverage can be treated as a constant throughout the lifetime of the investment. The barrier is normally known as a “knock-out” barrier, because if it is touched at any time the underlying option will expire worthless, irrespective of the level of the underlying on the expiry date, and the investor loses his or her entire investment. As the graph shows, the turbo is worthless under the knock-out barrier, but increases very rapidly in value as long as the barrier is not touched. Let us assume an investor has two alternatives: to buy a call warrant on ABC share with a strike of E100 for E12, and a turbo bull warrant with strike and barrier at E100 for E6. If at expiry the ABC share closes at E120, and over the life of the warrant never touched E100, the payoff of the call warrant and of the turbo bull is exactly the same, i.e. E20. Note that the initial price of the turbo warrant was much lower. If at expiry the ABC share closes at E120, but during the life of the warrant it traded at E100 (even just once) then the payoff will be E20 for the call warrant and zero for the turbo bull warrant.

Advantages of turbo warrants

• High deltas – their price is almost entirely dependent on the evolution of the price of the underlying
• Low vega – very small impact from implied volatility changes
• High leverage – resulting from a lower euro premium

Disclaimer

Investors are advised to discuss the risks and suitability of the product for their investment objectives with their financial consultant/broker. Although information in this report has been obtained from and is based upon sources thought reliable, neither Citibank AG nor any other company of Citigroup Inc. takes any responsibility for the accuracy of the content, and it may be incomplete or condensed.