Warrants

Warrants

• There are 2 types of warrant traded in bursa, i.e. Company Warrants and Structure Warrants
• It is a derivatives whose value depends upon  an underlying share listed in Bursa.
• It serve as tools for hedging, speculating and arbitraging.

Company Warrants

• It is issued by the company to raise money. 
• Normally, it was issued “free” as a "sweetener" for a bond, preferred stock, or rights  offering. 
• It is a right, but not an obligation, to subscribe for new ordinary shares at a specified price during a specified period of time. 
• It have a maturity date (up to 10 years) after which they expire are worthless unless the holder subscribes for the new shares of the company before the maturity date. 
• It generally American style option which can be exercise any time by paying the exercise price and convert to the underlying shares before the expiry of the warrants
• It represent a potential source of equity capital in the future and can thus offer a capital-raising option to companies.

Structure Warrants

• It is a proprietary instruments issued by a third-party issuer (e.g. investment bank).
• It give holders the right, but not the obligation, to buy or sell the underlying instrument in the future for a fixed price.   
• There is no conversion to the underlying share. 
• They are essentially European style option with cash settlements only with the investment bank at expiry date.

The Lingo

•  Strike Price \ Exercise Price, X 
• The price at which an underlying stock can be purchased or sold.
• A stock price must go above (for calls) or go below (for puts) before a position can be exercised for a profit.
• It must occur before the expiration date.
•  Premium, P
• The total cost (the price) of a warrant
• It is determined by factors including the stock price, strike price, time value and volatility.
• P = (W + X ) / S – 1
• W = Warrant Price
• X = Exercise Price
• S = Underlying Share Price
• There are 2 components of the premium are the intrinsic value (IV) and the time value (TV), P = IV + TV
• Intrinsic Value is the difference between the underlying share price (S) and the exercise price (X), IV = S – X
• Hence P = (S-X) + TV
• The lower the premium the more valuable the warrant.  
• The more time to expiration, the greater the time value of the warrant. - time increases the likelihood that the position can become profitable. Time value decreases over time and decays to zero at expiration. 

Factor that influence warrant price

• Underlying Share Price
• if the price of the stock is below the strike price of the warrant, there is no reason to exercise the warrant
• Days to Maturity
• It is worth less as time goes on and expiration approaches.
• Time Decay - it will accelerate as expiration approaches if the strike price is above the current price.
• Dividend
• Warrant-holders are not entitled to receive dividends
• The corresponding reduction in the stock price reduces the value of the warrant.
• Interest Rate / Risk Free Rate
• Higher interest rates increase the value of warrants.   
• The influence of this factor is small.
• Volatility, σ
• It is measured by the annual standard deviation of return of the underlying share.
• The higher the volatility or the movement of the underlying share price, the higher the odds that the warrant will eventually be in the money and the higher the value of the warrant will be.
• Dilution
• The exercise of volume will increase company's outstanding shares.
• This adds a twist to valuation that is not present in normal option valuation.
• Restriction on Exercise
• Any restrictions on the exercise of warrants will impact the value of a warrant negatively.
• E.g. the different between American-style and European-style warrants; American-style warrants permit exercise at any time, while the later can only be exercised on the expiration date. 

Why buy warrants instead of underlying share?

• Speculation
• Betting on the movement of a security.
• It is the territory in which the big money is made - and lost. 
• You have to be correct in determining
• The direction of the stock's movement
• The magnitude and the timing of this movement. 
• Leverage
• When you are controlling 1000000 shares of warrants, it doesn't take much of a price movement to generate substantial profits.
• Gearing
• The ratio of the share price to the warrant price
• It reflects how much the price of the warrant changes for a given change in the stock. 
• The higher the gearing, the more valuable the warrant.

Valuing Warrants with the Black-Scholes Model

• This formula is for European-style options and, though American-style options are theoretically worth more, there is not much difference in price in practice.
• The valuation of a warrant is expressed as: W = S N(d₁) - X e^-rT N(d₂)
• W= price of the warrant
• S = price of the underlying stock
• X = option exercise price 
• r = risk-free rate 
• T = time until expiration 
• N() = area under the normal curve
• d1 = [ ln(S/X) + (r + σ2/2) T ] / σ T1/2
•  d2 = d1 - σ T1/2
• Because of the dilution that warrants represent, the value of that call needs to be divided by (1 + q) where q is the ratio of warrants to outstanding shares, assuming each warrant is worth one share. 

References:-

• Company warrants and structure warrants kcchongnz (private)