Functionality – for experts
Since the issuer generally does not take a counter-position to the investor, he strives to hedge himself directly on the market. However, the product structure behind an inline warrant is one of those exotic options for which closed financial-mathematical valuation and risk management models exist, but which cannot be traded directly on the futures markets. Therefore, when hedging exotic options whose common feature is the barrier, issuers resort to combinations of classic call or put options in order to create a very similar opportunity/risk profile.
The specific hedging strategies may vary from issuer to issuer. Basically, since inline warrants increase in value daily with constant underlying prices and constant volatility, issuers must build up a hedging position from options that generates a daily net time value gain (metric theta).
The forward price of the underlying, which includes any distributions, such as dividends, is already discounted and is included in the pricing of both exotic and classic warrants. An adjustment of the barrier of an inline warrant therefore does not have to take place on the day of the dividend payment.
If investors sell their inline warrants back to the issuer at any point in time, the issuer immediately liquidates the hedging position. If investors get out of their inline warrants with a large profit, then the issuer is always able to actually pay them out thanks to the hedging position. If, on the other hand, the issuer’s position is negative because the market has risen or volatility has fallen, the investor realizes a loss of the same amount. In principle, the issuer acts free of conflicts of interest through its hedging transactions.