What Are Warrants and the Advantages of Buying

What are Warrants?


They are contracts that give the buyer or the owner the right to purchase a specified number of ordinary shares at a specified price ("the exercise price") some time in the future. The warrant is basically an option, where one warrant usually entitles the holder to purchase one ordinary share.

Generally, there are two types of warrants - European-style and American-style. The former can be exercised only on the expiry date while the latter can be exercised at any time up to the maturity.
 

Why Are Warrants Attractive?


Warrants are attractive because they provide investors with leverage opportunities and speculative appeal. Warrants offer significant leverage to investors because for a small initial investment, the holder can earn large rates of return (compared to investing in the underlying stock). In other words, warrants offer investors who want exposure to a particular stock a cheaper alternative.

Illustrative example - leverage opportunities
The price of, say, ABC Co. Ltd warrants is $0.90 while the underlying stock price was $3.25. If the price of the stock increases by $0.10 (and assuming that the price of the warrant also increases by the same amount), we can calculate the returns on the investments as follows:

For the warrant investor.
The return on investment would be 11.97 per cent, computed as follows:
Return (warrant)
= [(1.00 - 0.90)/0.90] x 100%
= 11.11%

For the stock investor.
The return on investment would only be 3.08 per cent, computed as follows:
Return (stock)
= [(3.35 - 3.25)/3.25] x 100%
= 3.08%

Hence, in this instance, we observe that the percentage gain for the warrant holders is much larger compared to the returns to the stockholders (11.11 per cent compared to 3.08 per cent). Also, the investment for the warrant holder is much lower ($0.90) compared with $3.25 for the stock.

Warrants also offer investors an opportunity to speculate on the underlying stock. Investors are willing to pay a premium over the "intrinsic value" of the warrant if they believe the price of the underlying stock has a good chance of exceeding the exercise price (the price at which the warrant holder can purchase the specified number of underlying shares in the future, also known as the strike price) of the warrant in the future.
 

Determining the Intrinsic Value


The intrinsic value of a warrant is determined by the exercise price, time to maturity (the remaining life of the warrant) and the underlying stock price itself. The value of a warrant is usually determined using the Black-Scholes option-pricing model, which requires two other factors, namely, the volatility of the underlying stock price as well as the risk-free interest rate to be estimated.

Alternatively, we can intuitively establish the intrinsic value of the warrant given that it derives its value from the value of the underlying stock. We can determine a price range in which the warrant must trade (the maximum and minimum price). After all, the maximum value of the warrant can never exceed the price of the underlying stock itself because there is no value beyond the value of the stock. The minimum value of the warrant is either zero (if the current market price of its underlying stock is less than the exercise price) or the difference between the current market price of underlying stock and the exercise price (if current market stock price exceeds exercise price).

The minimum value is generally referred to as the "intrinsic value" of a warrant. In practice, the warrant usually sells above this value (or at a premium). Investors pay this premium for the speculative value of the warrant.
 

What Determines the Speculative Value of Warrants?


Investors may be willing to pay a premium for warrants that have the following characteristics.

First, warrants with longer remaining life are generally more valuable. Currently unattractive warrants may become attractive six months or two years from now if the price of the underlying stock appreciates. The option for companies to extend their expiring warrants will also see the price of their outstanding warrants increase substantially.

Second, all things being equal, investors are likely to pay a higher premium if the underlying stock is more volatile. A warrant will have a higher probability of appreciating in value during its life, and eventually being exercised if the price of the underlying stock has a volatile trading range.

Thirdly, if the underlying stock is expected to pay dividends, the premium for its warrants will be reduced - this is because warrant holders do not receive any dividend while shareholders do.

And lastly, the premium which investors would be prepared to pay in order to speculate on the warrants depends very much on its leverage potential. As illustrated earlier, the rate of return on warrants is generally higher compared to the rate of return on the underlying stock. Some warrants have greater leverage possibilities than others and as such command a higher premium.
 

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