Introduction
Knock-out warrants (turbos), like vanilla warrants, derive their value from the difference between the price of the underlying and the strike. They differ significantly however from vanilla warrants in many important respects:
- They can expire (knock-out) prematurely if the price of the underlying instrument touches or falls below (in the case or knock-out calls) or exceeds (in case of the knock-out puts) a predetermined barrier-level. It expires worthless if the barrier equals the strike, or it may have residual stop-loss value if the barrier is set higher than the strike (in the case of a call).
- Changes in implied volatility have little or no impact on knock-out products, therefore their pricing is easier for investors to comprehend than that of warrants.
- They have little or no time value (because of the presence of the knock-out barrier), and therefore have a higher degree of leverage than a warrant with the same strike. This is because of the absence of time value makes the instrument "cheaper".
Pay-out Profile
Leverage
As discussed above, knock-out warrants exhibit high degrees of leverage, particular as the price of the underlying nears the strike/barrier. Consider following the example of long turbo on the Dow Jones Index, compared to a vanilla warrant:
Intrinsic value = (index value - strike) x ratio
Leverage = index value x ratio / instrument price
A vanilla warrant retains significant time value even as the underlying price approaches the strike, sharply reducing its leverage compared to a knock-out warrant
Product Types
As discussed above, the barrier may either equal the strike, or be set above (calls) or below (puts). In the latter cases a small residual value remains after knock-out, corresponding to the difference between the barrier (the stop-loss level) and the strike. Moreover, knock-out products may either have an expiration date or may be open-ended. This makes a difference in the way interest is accounted for. If the contract has an expiration date interest is included in the premium, the amount of which reduces over time and is zero on expiration. This is analogous to a standard vanilla warrant.
In relation to an expiration date. The price of the contract therefore corresponds exactly to its intrinsic value. Interest however is accounted for. This is done by a daily adjustment to the barrier and strike. The following example shows the daily adjustment for a long open-ended turbo on the Dow Jones Inex:
The adjustment = Strike T x (1 + FedFunds/360 + Issuer Spread/360).
The intrinsic value of the instrument is correspondingly reduced as follows, assuming no change in the value of the Dow Jones Index):
Intrinsic value = (index value - strike) x ratio