The price of warrant is determined by the factors as follow:
1.
The price of the mother share (or underlying
security)
2.
Exercise price
3.
Time to expiry
4.
Share price volatility
5.
Interest rate
6.
Dividend rate
When the following increases…
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Impact on Call Warrants Price
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Impact on Put Warrants Price
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Share price
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Exercise price
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Time to expiry (getting neared to expiry)
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Share price volatility
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Interest rate
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Dividend rate
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Share Price
As warrant is derivative from the underlying security or
share, there is a direct relationship between the share price and the price of
the warrant. For call warrant, the relationship between underlying share price
and warrant is positive. When the share price rises, the greater the chance the
warrants get exercise and therefore the warrant price increases. For put
warrant, the situation is reversed. When the underlying share price rises, the
lesser chance the investors exercise the right and therefore the price of the
put warrant drops.
Nevertheless, the price of the warrant may not necessarily follow
the underlying share as it has its own demand and supply, and in the case of
structured warrants, the market making of the issuer is based on implied
volatility.
Exercise Price
The exercise price of a call warrant has an inverse
relationship with the price of the latter. The higher the exercise price, the
lower the price of the warrant as warrant holders will need to pay more to
exercise the warrant. Again, the reverse is true for the put warrants.
Exercise price is usually set prior to the issue of the
warrant. It can be set at a premium or at a discount of the prevailing market
price. It cannot be set lower than the par value of the ordinary share because
it involves the issuance of new share (new shares cannot issued at a lower
price lower than its par value).
The exercise price normally fixed for the entire life of the
warrant. However, there are instances whereby the exercise price can be
adjusted (usually upwards for call warrants and downward for put warrants) when
a certain time line is hit. Warrants with a step-up pricing mechanism for the
exercise price were usually done to encourage early conversion so that the
company can raise some funds earlier. There are also warrants with step-down
exercise pricing mechanisms to avoid dilution of shares due to early exercise
of warrants.
Time to Expiry
The value of a warrant in theory can be divided into two
parts:
Warrant
Price = Intrinsic Value + Time Value
Time value is the value attached to the time left to
maturity. A warrant that has 12 months left to maturity is worth more than a
warrant with 3 months left because a 12-month warrant offers the warrant holder
a greater chance for the underlying of moving in-the-money.
Effectively, time value represents the speculative value of
the warrant that the investor pay the benefit from a favorable change in the price
of the underlying, during the life of the warrant. As the warrant moves closer
to maturity, the time value also decreasing.
Share Price
Volatility
An important element affecting the price of a warrant is the
volatility of the underlying security. The more volatile the underlying, the
greater the potential profits from the warrant. High volatility indicated that
the underlying asset price varies sharply (both up and down) and could exceed
investor expectations. Thus, both call and put warrants prices are benefited by
higher volatility.
There are two types of volatility:
·
Historical volatility: Calculated based on past
variations in the price of the underlying. Past variations give some idea of
the potential for future variations.
·
Implied volatility of a warrant represents
market expectation of future volatility in the price of the underlying
security.
Implied volatility
The implied volatility of a warrant represents market
expectation of future volatility in the price of the underlying security. When
the implied volatility is 50%, this means that the normal range of a share
price’s movement is +50% to -50% on an annualized basis.
This can be converted into the expected normal trading range
over the shorter period by dividing the annualized volatility by square root of
the number of those periods in a year. For example, there are 260 trading days
in a year, so a “normal” daily movement would be +-3.1% (+-50% / √260).
Warrant issuers typically make money by making a spread on
volatility. This is usually done by marking up and down the implied volatility
of the bid and ask price of the liquidity providers. In more mature markets,
issuers base the implied volatility from the corresponding options market on
the underlying security. In the absence of a corresponding options market, issuers
would have to look at the underlying security’s historical volatility as a
gauge for the bid and ask quotes.
A warrant is said to be fairly priced when the implied volatility
of the warrants is close to the historical volatility of the underlying
security. In most instances, a warrant can be said undervalued when its implied
volatility is less than the historical volatility.
Interest
Rate
Buying call warrants can be seen as buying the underlying
securities or the mother share on margin as the warrant investor only comes up
with fraction of the cost of buying the share. Therefore, when the interest
rate rises, the value of the warrant should rise to reflect the “higher
financing cost” to purchase the share.
For put warrants, a sale of underlying securities may take
place at expiry. The situation is therefore the reverse (the higher the
interest rate, the lower the premium). In fact, if the investor had sold the
shares directly instead of buying a put, he/she would been able to invest the
proceeds of the sale in the money market and would have received interest
income from this.
Dividend Rate
The warrant holder is not entitled for any dividend payment
unless he exercises the warrant prior to the entitlement date of the dividend. As
warrant holders are not expected to exercise the warrants prior to expiry in a
perfect market, expectation of a higher dividend rate will have a negative
impact on the price of the warrant.
For put warrants, higher dividends add to the attractiveness
of the warrants because the share price would be adjusted downwards in a bigger
magnitude when the share goes ex-dividend.
For structured warrants, an issuer usually takes into
consideration the expected dividend from the underlying share during the
warrant’s tenure in determining the issue price of the warrant. Hence, if the
dividend rate is as per expected, the price of the warrant should not be
affected. However, if the dividend rate is above expectation, the price of the
warrant will likely to be affected, although if the share price rises on a
higher than expected dividend payout, the negative effect of the higher than
expected dividend rate may be mitigated.
