WARRANT INSIGHTS
Understanding implied volatility
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LAST week we looked at historic volatility, so this week we'll examine the more important side of the volatility spectrum, known as implied volatility. Before doing so, however, it's worth looking at how you can convert an annual figure to suit a shorter time frame.
If, for example, the annual historic figure is given as 32 per cent but you need the figure for one quarter or three months, all you have to do is multiply the annual figure by the square root of the period in question.
In this case, the period is one quarter and the square root is one-half. So 32 per cent annualised volatility becomes 16 per cent over a three-month period. This in turn tells us that there is a 68 per cent chance - one standard deviation - that the stock's return will fall between -16 and +16 per cent over the next three months.
Similarly, to convert to a monthly number, multiply by the square root of 1/12 to get 9.2 per cent. If there are 256 trading days in the year, multiply the 32 per cent by the square root of 1/256 to get daily volatility of 2 per cent.
So much for history. We all know that the past may not be a good predictor of the future and that markets are more concerned with the future than the past. This is where implied volatility comes in.
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All warrant issuers use pricing models in their daily market-making activities. These models require future volatility as a key input. And because this is not known, estimates have to be found. These come from the over-the-counter (OTC) options market.
Recall from our July 7 column that issuers tap into this market to hedge their risk. Because market prices are available, it is possible to plug these prices into the various pricing models and work backwards to obtain volatility figures.
The resulting numbers represent the volatilities implied by market prices and hence are known as implied volatilities. They are then used by issuers to price their warrants at issue and on a daily basis.
In general, therefore, when there are changes in implied volatilities in the over-the-counter options market, there will be changes to warrant prices.
Also, in general, an increase in implied volatility leads to a higher warrant price, while a lower implied figure leads to a lower price.
This column is brought to you by Merrill Lynch
Please send your questions to btwar@sph.com.sg
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