Risk Latte - Trading Range Warrants on BSE Sensex 30*

Trading Range Warrants on BSE Sensex 30*

Team Latte
Mar 22, 2006


The BSE Sensex 30 (the bellwether indicator of Indian stocks) briefly touched 11,000 mark yesterday which is a historical high. Some analysts and investors are worried that the Indian stock market is very expensive and is likely to fall (due to correction or even a mild crash) while others, mostly foreign institutional investors, are still very bullish on the market. They expect it to go much higher. But what if the BSE Sensex 30 in the next two years remains bound in the trading range of 9,000 and 12,000? This is a very un-sexy and uninteresting scenario, but nevertheless a very plausible one. For a very small number of investors who subscribe to this view we would like to suggest this particular product - a trading range warrant.

This warrant is designed such that in the event the BSE Sensex remains in a trading range of 9,000 to 12,000 then the investor gets a high yield via a zero coupon bond. However, if the BSE Sensex breaks away from the this trading range on either side the investor loses money.

The Trading Range Warrants on the BSE Sensex 30 will have a maturity of 2 years and a European style exercise. The warrant payoff would be: if at the end of two years, say March 31, 2008 the BSE Sensex stays within the range 9,000 and 12,000 then a single warrant pays off $1,000 on maturity date, while if at the end of two years the BSE Sensex is below the 9,000 mark then a single warrant pays off (1,000/11,000) * Index Value on the maturity date. If, however, the BSE Sensex is higher than 12,000 mark then a single warrant pays off (1,000/11,000) * (Index-11,000) on the maturity date.

Warrant Payoff:

Term Sheet:

Issuer:
Bank XYZ
Settlement:
April 1, 2006
Maturity:
March 31, 2008

Payoff at Maturity
$1,000
if BSE Sensex is between 9,000 and 12,000
$(1,000/11,000) * BSE Sensex
if BSE Sensex is less than 9,000
$(1,000/11,000) * (BSE Sensex - 11,000)
if BSE Sensex is greater than 12,000

Pricing of the Warrant:

We have done a back of the envelope pricing of the above product using a closed form Black-Scholes model (volatility of 16%, interest rate of 7%, maturity 2 years) and the price comes out to approximately $815. If the BSE Sensex remains in the trading range of 9,000 and 12,000 at the end of two years then the warrant pays of $1000 and the warrant price of $815 represents a yield of around 10.76%.

The pricing is done as follows:

The warrant can be decomposed as:

  • a long zero coupon bond paying $1,000 at the end of 2 years;


  • a short 0.09 put option on BSE Sensex with a strike price of 9,000


  • a long 0.09 call option on BSE Sensex with a strike price of 12,000


  • a short 0.09 call option on BSE Sensex with a strike price of 11,000


 


Of course, a more detailed and accurate pricing is required which will involve: (1) incorporating local volatility and volatility skew and (2) Monte Carlo simulation technique.


Scenario Analysis


This is a losing proposition for an investor if the Sensex break out of the trading range on maturity and in that event he may end up losing a lot of money. Only if the Sensex stays in the range of 9,000 and 12,000 on the maturity date the investor realizes very good yield. There is a small peculiarity in this warrant. In the unlikely event of Sensex breaking the upside barrier of 22,000 at the end of two years the investor will get back the face value of $1000 and realize the same yield as that if the Sensex had remained in the trading range.



*Copyright : This idea and the intellectual product is copyrighted by Risk Latte Company and any reproduction of this product/idea for commercial purposes by any party is not allowed and will be deemed illegal.

Disclaimer: Risk Latte Company is not a registered investment advisory company with any regulatory body and shall not be liable for any losses arising out of direct or indirect use of the above trading idea by any party. This illustration is strictly for educational purposes.

Any comments and queries can be sent through our web-based form.

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