Discount Warrants

Discount warrants represent an additional category of leveraged products alongside classic warrants, knock-outs and factor certificates. These products are also called “capped warrants”. The reason for this lies in the structure of these products. Both discount calls and discount puts are equipped with a so-called cap, which limits the maximum possible yield.

Discount Call

With a discount call, investors tend to take a position on potentially rising prices of a certain underlying. This can be an index such as the DAX®, the EURO STOXX 50® or the Dow Jones, a share or a commodity.

The most important features of the discount call are the strike price and the cap. They determine the risk-reward profile and the redemption amount. At maturity, the investor receives the difference between the price of the underlying and the strike price, whereas the redemption amount will not exceed the difference between the cap and the strike price (adjusted in each case by the ratio and, if the underlying is not denominated in euro, by the exchange rate). The redemption amount is always greater than or equal to zero and corresponds to the intrinsic value of the discount call.

Depending on the level of the underlying price compared to the strike price and cap, a discount call may have a leverage effect, i.e. that a one percent movement in the underlying can lead to a higher movement in the discount call. If the underlying is quoted significantly below the cap or even below the strike price, the leverage effect is relatively high. If, on the other hand, the underlying exceeds the cap, the discount call reacts less and less to price changes of the underlying.

The strike price and cap have further implications. If the underlying is at or below the strike price on the last valuation date, the discount call expires worthless. The cap, on the other hand, defines the maximum possible redemption amount and the maximum yield. The holder of the discount call only participates in price increases of the underlying up to the cap. If the underlying exceeds the cap, this has no impact on the redemption amount. Discount calls with high strike prices and high caps are more offensive than products with low strike prices and caps. In more offensive discount warrants higher chances are connected with higher risks.  

Redemption amount of the discount call (or intrinsic value) at maturity:

1. Price of the underlying is above or equal to the cap: Maximum redemption amount, i.e. ratio x (cap – strike price) x FX-rate

2. Price of the underlying is between strike price and cap: Ratio x (price of the underlying – strike price) x FX-rate

3. If the price of the underlying is equal to or below the strike price: 0

Discount Put

With a discount put, investors tend to take a position on potentially falling prices of a certain underlying. At maturity, the investor receives the difference between the strike price and the price of the underlying, but at most the difference between the strike price and the cap (adjusted in each case by the ratio and, if the underlying is not quoted in euro, by the exchange rate). The redemption amount is always greater than or equal to zero and corresponds to the intrinsic value of the discount put.

Discount puts can also have a leverage effect, i.e. that a one percent movement in the underlying can lead to a higher movement in the discount put. This leverage effect also depends on the level of the underlying price compared to the strike price and cap. If the underlying is considerably above the cap or even above the strike price, the leverage is relatively high. If, on the other hand, the underlying falls below the cap, the discount put reacts less and less to price changes of the underlying. Investors use puts not only to benefit from falling prices of an underlying. They can also be used to hedge the portfolio.

Redemption amount of the discount put (or intrinsic value) at maturity:

1. Price of the underlying is below or equal to the cap: Maximum redemption amount, i.e. ratio x (strike price – cap) x FX-rate

2. Price of the underlying is between cap and strike price: Ratio x (strike price – price of the underlying) x FX-rate

3. Price of the underlying is equal to or above the strike price: 0

Price development in the secondary market

The price development in the secondary market depends on several parameters. Rising prices of the underlying tend to increase the value of a discount call, while falling prices of the underlying usually decrease the value of the discount call. Conversely, falling prices of the underlying usually increase the value of a discount put, while rising prices of the underlying usually decrease the value of the discount put. In addition, other factors such as implied volatility impact the secondary market performance of discount warrants.

Discount warrants offer high profit opportunities that are offset by high risks of loss. In the worst case, a total loss can occur.

Risks

• Potential total loss: Due to the leverage, high losses are possible. In the worst case, total loss of the invested capital is possible.

• Change of leverage: The change of the underlying prices changes the leverage of discount warrants.

• Maximum redemption amount: The redemption amount will not exceed the maximum redemption amount, i.e. the possible yield on discount warrants has an upper limit.

• Impact of market factors: In the secondary market, factors such as implied volatility impact the price of discount warrants in a way that is sometimes difficult for investors to understand.

• Issuer risk: A total loss is possible if the issuer of the discount warrants and, if applicable, the guarantor become insolvent.

• Liquidity risk: Trading in the secondary market may be limited and investors bear the risk that they cannot buy or sell the products at any time and at a specific price (see information on Secondary Market for products issued by Goldman Sachs also here).