Using Black-Scholes Model to evaluate Structured Warrants

Black-Scholes model was developed by Fischer Black and Myron Scholes in 1973.  It is a mathematical model of a financial market containing derivative investment instruments (Read more here).  It is widely used, often with adjustments, to determine the price of options.

There are many types of derivative options in the market.  One of the most popular derivative options in Bursa Malaysia are the Structured Warrants (Read more here).  Today, I am going to discuss the usage of Black-Scholes model in Structured Warrants evaluation.

To construct a simple Black-Scholes model using excel, one can refer to this link.  I did some modification on the model in order to fit the characteristics of the structured warrants available in Bursa Malaysia.

The following table (Table 1) is the structured warrants price of the HSI-H53 as at 26-Jul-16.  To check the accuracy of the model, it is compared with the offer price by the issuer (Table 2).  This model was tested on other structured warrants as well; the accuracy is always within the spread of the structured warrants.

Table 1

Future Index	Black-Scholes Model HSI-H53 price
22120	0.429
22110	0.431
22100	0.432
21880	0.433

Table 2

The following snapshot (Picture 1), is the Black-Scholes model in excel format.  (Readers who are interested to construct the Black-Scholes model using Excel spreadsheet can contact me via email.  Private tutorial or class can be arranged.)

Picture 1

There are few variables that affect the structured warrant price.  The most significant factor is the underlying stock price.  In this example, it is the Hang Seng Future Index.  The following table (Table 3) shows the impact of Hang Seng Future Index changes to the HSI-H53 price.  Every 1% changes of the Hang Seng Index with cause the HSI-H53 price to fluctuate about 6%.

Table 3

Future Index	Put Option Price	Percentage changes of Index	Percentage changes of Put Option Price
23205	0.313862973	5.00%	-27.31%
22984	0.334834542	4.00%	-22.46%
22763	0.357055027	3.00%	-17.31%
22542	0.380583676	2.00%	-11.86%
22321	0.40548107	1.00%	-6.10%
22100	0.431809	0%	0%
21879	0.459630311	-1.00%	6.44%
21658	0.489008773	-2.00%	13.25%
21437	0.520008864	-3.00%	20.43%
21216	0.552695579	-4.00%	28.00%
20995	0.587134208	-5.00%	35.97%

The second significant factor that will impact the option price is the holding period.  In option trading, “buy and hold” strategy is “No”, “No”, “No”.  Because it is very important, so have to say it three times.  The following table (Table 4) shows the holding period impact of the put option.

Table 4

Hang Seng Future Index	Holding Duration	Warrant Price	%
22100	0	0.431	0
22100	3	0.422	-2.09%
22100	5	0.416	-3.48%
22100	10	0.399	-7.42%
22100	14	0.386	-10.44%

  

From the table we can see that, even the underlying Hang Seng Future Index stays constant, by holding the put option for 3 days, the option price will automatically reduce by 2.09%.  As such, in side way market, where the Index stay about the same level for long period of time, eventually the option price will diminish to zero value.

There is another important variable in Black-Scholes model, which is the implied volatility.  This is the most difficult variable to determine.  There are many ways to estimate but for now, the easiest way is to use the implied volatility rate provided by the structured warrants issuer.

In summary, traders who are interested in structured warrants trading can use the Black-Scholes model to evaluate the risk and return.  The key principle is – Do not apply “buy and hold” strategy on option trading.  Unless the option is deep in the money and the trader is ready to exercise the option on maturity.  That will be discussed in another article.

Disclaimer:  The above option price calculations do not imply any buy or sell recommendation.   The author disclaims all liabilities arising from any use of the information contained in this article.