Bankers Trust American Style Installment Put Warrants
May 24, 2005
Team Latte

Installment warrants, unlike installment options, are rare to come and even rarer is American style installment warrants. These days it almost impossible to come by a retail warrant issue that is American style and has installment features priced in. The most important reason for this is that they are extremely difficult to price.

On April 14, 1994 Bankers Trust Canada issued installment put warrants on the TSE-35 index. These warrants had the following characteristics: say an investor bought 10,000 such warrants, then for him the terms would be

Premium Paid:

This means on the date of purchase the investor will only pay part of the warrant price (premium), i.e. C$2.50 and receive the option to buy the warrants with a fixed two year maturity. After one year, the investor may choose to pay another C$2.50 and receive an American put option in the TSE-35 or not pay the balance and let the option expire worthless. Once the investor decides to go ahead with the payment of the balance amount he receives an American put on the TSE-35 which can be exercised any time between the installment payment date and the exercise date.

Please note that the pricing of the above installment warrant could literally become a nightmare for the uninitiated (and lesser mortals like us at Risk Latte).

Questions:

1. Is this a compound option? And if so, then are both options American style options?
2. Does the installment feature add leverage to the structure? Explain what will be the return to the investor if above warrant increases in price by C$0.50 before the installment payment date.
3. The expression of the Banker's Trust warrant can be written as:

   Where, is the American put option on the TSE-35 with a strike price of and is the strike price of the European style call option on the American style put.

4. • (a) Is the above expression correct?
   • (b) Are the limits of the integration appropriate or should then be from K(1) to infinity?
   • (c) Can Geske's and Rubenstein's method (using Newton-Raphson's method to iteratively solve a non-linear equations) be applied to the above problem? (Simply answer in one sentence).

References:

See Izzy Nelken excellent paper Compound Options and Chooser Options in Exotic Options by Izzy Nelken (Here he describes how to price Compound and Chooser Options using Numerical Quadrature approach and where the Bankers Trust case is also mentioned.)

Disclaimer:
Risk Latte Company does not accept any liability due to factual or technical incorrectness or flaws in the above article.

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