Warrants

A warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiration date. Some important characteristics to consider include the following:

• A warrant is exercised when the holder informs the issuer of their intention to purchase the shares underlying the warrant.
  
  
• A warrant's "premium" represents how much more you pay for your shares when buying them through the warrant than when buying them the regular way.
  
  
• A warrant's "gearing" is the way to ascertain how much more exposure you have to the underlying shares using the warrant than the exposure you would have if you bought the shares through the market.
  
  
• If you exercise the warrant, you must do so before the expiration date. The more time remaining until expiration, the more time it takes for the underlying security to appreciate, which, in turn, will increase the warrant's price (unless it depreciates). Therefore, the expiration date is when the right to exercise ceases to exist.
  
  
• Like options, warrants have different exercise types, such as American style (the holder can exercise anytime before expiration) or European style (the holder can only exercise on the expiration date).

Sometimes, the issuer will try to establish a market for the warrant and register it with a listed exchange. In this case, the price can be obtained from a stockbroker. Often, though, warrants are privately held or not registered, which makes their prices less obvious.

Warrants Versus Other Convertibles

Warrants are very similar to call options. For instance, many warrants confer the same rights as equity options, and warrants often can be traded in secondary markets like options. However, there are several key differences between warrants and equity options:

• Warrants are issued by private parties, typically the corporation on which they are based, rather than a public options exchange.
  
  
• Warrants issued by the company are dilutive. When the warrant is exercised, the company issues new shares of stock, increasing the number of outstanding shares. When a call option is exercised, the owner receives an existing share from an assigned call writer. Unlike common stock shares outstanding, warrants do not have voting rights.
  
  
• Warrants are considered over-the-counter instruments and, thus, are usually only traded by financial institutions with the capacity to settle and clear these types of transactions.
  
  
• A warrant's lifetime is measured in years (as long as 15 years), while options are typically measured in months. Upon expiration, the warrants are worthless unless the price of the common stock is greater than the exercise price.
  
  
• Warrants are not standardized like exchange-listed options. While each option contract generally contains over 1,000 underlying ordinary shares, the number of warrants that the holder must exercise to buy the underlying asset depends on the conversion ratio set out in the offer documentation for the warrant issue.

Valuation

There are various methods of evaluating warrants, the most popular being the Black-Scholes evaluation model [see section on Options]. However, it is important to understand the various influences on warrant prices. The market value of a warrant can be divided into two components:

Intrinsic value: This is simply the difference between the exercise (strike) price and the underlying stock price. Warrants are also referred to as in-the-money or out-of-the-money, depending on where the current asset price is in relation to the warrant's exercise price. Thus, for instance, for call warrants, if the stock price is below the strike price, the warrant has no intrinsic value (only time value – to be explained shortly). If the stock price is above the strike, the warrant has intrinsic value and is said to be in the money.

Time value: Time value can be considered the value of the continuing exposure to the movement in the underlying security that the warrant provides. Time value declines as the expiration of the warrant approaches. This erosion of time value is called time decay. It is not constant but increases rapidly towards expiration. Time value is affected by time to expiration, volatility, dividends, and interest rates.

Traditional warrants are issued in conjunction with a bond (known as a warrant-linked bond) and represent the right to acquire shares in the entity issuing the bond. In other words, the writer of a traditional warrant is also the issuer of the underlying instrument. Warrants are issued in this way to reduce the interest rate that must be offered to sell the bond issue. Valuing this type of warrant can be accomplished with the following equation:

\( \begin{align*}P_0 = \left(\sum_{l=1}^T \frac{C}{(1+r)^l}\right) + \frac{F}{(1+r)^T}\end{align*} \).

Valuing a Warrant Where P is the price paid for the bond with warrants, C is the coupon payment, T is the bond's maturity, r is the required rate of return, and F is the bond's face value.

Uses, Advantages, and Disadvantages

Warrants are often used as deal sweeteners to entice hesitant investors. However, a warrant only benefits the investor if the company grows. Warrants can also be used for portfolio protection. For example, put warrants allow the owner to protect the value of the owner's portfolio against falls in the market or in particular shares. Because of the dilutive nature of warrants, their issuance can lead to decreased stock value and loss of voting control. Warrants may also carry liquidity risk due to their specialized nature.

Source: Boundless Finance, https://ftp.worldpossible.org/endless/eos-rachel/RACHEL/RACHEL/modules/en-boundless-static/www.boundless.com/finance/textbooks/boundless-finance-textbook/options-and-corporate-finance-16/warrants-119/index.html
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