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10.7.2 Warrants

Learn everything about warrants in this comprehensive guide: their characteristics, valuation, and advantages, along with essential definitions and key takeaways.

Warrants

A warrant is a security that gives its holder the right to buy shares in a company from the issuer at a set price for a specified period of time. In this respect, warrants are similar to call options. The primary difference between the two is that warrants are issued by the company itself, while call options are issued (i.e., written) by other investors.

Warrants are often issued as part of a package with a new debt or preferred share issue. This practice makes these issues more attractive to buyers by offering them the chance to participate in the issuer’s common shares’ potential appreciation. Warrants can function as a ‘sweetener’ for such investment packages.

Once issued, warrants can be sold either immediately or after a holding period. The expiration period of warrants is usually longer than that of a right and can extend up to several years from the date of issue.

Valuing Warrants

Similar to options, warrants can have both intrinsic value and time value:

  • Intrinsic value: The difference between the market price of the underlying stock and the warrant’s exercise price.
  • Time value: The amount by which the market price of the warrant exceeds its intrinsic value, reflecting the remaining time until the warrant’s expiration.

Valuation Example

Consider a warrant to buy one common share at $40 when the stock’s market price is $30. This warrant has no intrinsic value because the market price of the common stock is less than the exercise price. However, it can still hold a market value due to its time value.

Calculation

  • Intrinsic Value: $15 - $12 = $3
  • Time Value: $4 - $3 = $1

If the common stock rises to $23 per share before the warrants expire, the results are as follows:

For the Warrant Buyer:

Before After
Price of Warrant $4 $11

The holding period return is: 175%

For the Common Stock Buyer:

Before After
Price of Common Stock $15 $23

Returns: $8 (approx 53%).

Here, warrant buyers achieve returns greater on a percentage basis than those who invested in the common stock.

Of course, the opposite scenario can create major losses. For instance, if the stock decreases to $10 per share:

The Warrant Buyer: There would be no intrinsic value and likely only time value, resulting in a nearly 94% loss.

The Common Stock Buyer: Expects a 33% loss.

Why Investors Buy Warrants

The primary advantage of buying warrants lies in their leverage potential. Because the market price of a warrant is usually much lower than the price of the underlying security, warrants generally move in sync with the underlying stock and can result in higher percentage returns.

Example

Louis and Beatrice buy a warrant and its underlying stock respectively. Here we’d originate the initial intrinsic-ended and time-valued warrant-looking low-to-high movement potential, calculated returns of acquisition price vs leverage intrinsic value & common lifeline.

Key Terms & Definitions

  • Warrant: A security giving the holder the right to purchase shares at a predetermined price.
  • Exercise Price: The set price at which a warrant holder can buy the share.
  • Intrinsic Value: The value where the market price exceeds the exercise price.
  • Time Value: Extra value a market attaches due to time until warrant expiry.

Discussion Questions

  • How does the time value of a warrant change as it nears expiration?
  • What main factor differentiates warrants from call options?

Key Takeaways

  • Warrants are similar to call options but are issued by the company itself.
  • The value of warrants lies in their potential for high leverage due to a usually minimal initial investment relative to the beneficial price enhancement.
  • Valuating key intrinsic versus time value variables can crucially impact potential gain/loss understanding immediately or speculation remaining.

Participation Notes Scenarios & Terminology Introduction/Q&A Assessment across fitments.


CSC® Exams Practice Questions

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## What is a warrant in the context of securities? - [ ] A short-term debt instrument - [x] A security that gives its holder the right to buy shares at a set price for a set period - [ ] A type of mutual fund - [ ] A government bond > **Explanation:** A warrant is a type of security that grants the holder the right to purchase shares from the issuer at a predetermined price within a specific timeframe. ## How do warrants generally differ from call options? - [ ] Warrants are issued by third-party investors - [x] Warrants are issued by the company itself - [ ] Warrants do not have an expiration date - [ ] Warrants cannot be sold in the market > **Explanation:** Unlike call options, which are written by other investors, warrants are issued directly by the company that also issues the underlying shares. ## What is the intrinsic value of a warrant? - [ ] The difference between the exercise price and the market value of the warrant - [ ] The exercise price of the warrant - [x] The amount by which the market price of the underlying stock exceeds the exercise price - [ ] The market value of the warrant itself > **Explanation:** The intrinsic value of a warrant is the amount by which the market price of the underlying stock exceeds the exercise price of the warrant. ## What happens to the time value of a warrant as its expiration date approaches? - [ ] It increases - [x] It decreases - [ ] It remains constant - [ ] It becomes irrelevant > **Explanation:** The time value of a warrant decreases as it approaches its expiration date, since there is less time remaining for the underlying stock to increase in price. ## When can warrants be sold? - [ ] Only when they have intrinsic value - [x] Either immediately or after a certain holding period - [ ] Only after the final expiration date - [ ] They cannot be sold once issued > **Explanation:** Warrants can usually be sold either immediately or after a specific holding period, depending on the terms set by the issuing company. ## Why are warrants often issued along with new debt or preferred share issues? - [ ] To dilute existing shareholders - [x] To make these issues more attractive to buyers - [ ] To comply with financial regulations - [ ] To reduce the company's leverage > **Explanation:** Warrants serve as a sweetener for new debt or preferred share issues, making them more appealing to investors by offering the potential for additional gains through the issuer's common shares. ## What does the leverage potential of warrants refer to? - [ ] Risk reduction - [ ] Increased dividends - [x] Greater percentage capital appreciation compared to the underlying security - [ ] Lower initial investment required > **Explanation:** The leverage potential of warrants allows for greater percentage gains in value compared to the underlying security, often with a lower initial investment. ## What would be the impact of a decline in the price of the common stock on the warrant? - [ ] It would increase its intrinsic value - [ ] It would not affect the warrant - [x] It would likely cause a significant loss in the warrant's value - [ ] It would only affect the time value of the warrant > **Explanation:** A decline in the price of the common stock will likely result in a significant loss in the warrant's value, potentially reducing it substantially or rendering it worthless if it loses intrinsic value. ## What is the market value of a warrant composed of? - [ ] Only intrinsic value - [ ] Only time value - [ ] Exercise price - [x] Intrinsic value and time value > **Explanation:** The market value of a warrant is composed of both its intrinsic value, which is the difference between the market price of the underlying stock and the exercise price, and its time value. ## Which factor primarily contributes to the time value of a warrant? - [ ] Historical performance of the stock - [x] The remaining time until the warrant's expiration - [ ] The age of the issuing company - [ ] The dividend yield of the underlying stock > **Explanation:** The primary factor contributing to the time value of a warrant is the remaining time until its expiration. The longer the time remaining, the higher the possibility that the underlying stock's price might increase, thus providing value to the warrant.

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Sunday, July 21, 2024