Factors affecting the price of warrants

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…	Impact on Call Warrants Price	Impact on Put Warrants Price
Share price	↑	↓
Exercise price	↓	↑
Time to expiry (getting neared to expiry)	↓	↓
Share price volatility	↑	↑
Interest rate	↑	↓
Dividend rate	↓	↑

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.