The value of a warrant is influenced by the six market variables outlined in the table below. The arrows indicate which direction the value of call or put warrants will move in response to a change in the corresponding variable in most situations.
| Variable |
Change in variable |
Change in call
warrant price |
Change in put
warrant price |
| Underlying share price |
|
|
|
| Exercise price |
|
|
|
| Time to expiry |
|
|
|
| Dividend Expectations |
|
|
|
| Volatility |
|
|
|
| Interest rates |
|
|
|
Share price
The underlying share price is the key driver of the warrant price. As the share price increases, the value of a call warrant should increase. Conversely, the value should fall as the share price falls.
The opposite occurs for put warrants. Put warrants should increase in value as the share price falls and decrease in value as the share price rises.
By successfully predicting the price direction of shares, investors can profit from trading warrants on positive and negative views.
The tables below demonstrate the anticipated movements of a call warrant and a put warrant investment. In estimating the returns an assumption has been made that there will be a 10% increase and a 10% decrease in the share price at the end of a 3 month investment period.
|
Investor purchases 10,000 XYZ Macquarie Call Warrants for $1.00 each. XYZ's share price is $10.00.
|
| Share price in 3 months |
$9.00
|
$10.00
|
$11.00
|
| Number of Warrants |
10,000
|
10,000
|
10,000
|
| Warrant price in 3 months |
$0.40
|
$0.85
|
$1.50
|
| Purchase price |
$10,000
|
$10,000
|
$10,000
|
| Sale proceeds |
$4,000
|
$8,500
|
$15,000
|
| Return on Call Warrant |
(60)%
|
(15)%
|
50%
|
| Return on Share Investment |
(10)%
|
0%
|
10%
|
Clearly, when the share price increased, the warrant provided a better return than the underlying share. While the share price increased $1.00 (from $10.00 to $11.00), that is 10%, the call warrant increased $0.50 (from $1.00 to $1.50), providing a 50% return.
Note: When the share price remains constant at $10.00, the warrant price falls 15% (from $1.00 to $0.85) during the three month investment period. This is due to time decay.
| Investor purchases 10,000 XYZ Macquarie Put Warrants for $1.00 each. XYZ's share price is $10.00. |
| Share Price in 3 months |
$9.00
|
$10.00
|
$11.00
|
| Number of Warrants |
10,000
|
10,000
|
10,000
|
| Warrant Price in 3 months |
$1.50
|
$0.85
|
$0.40
|
| Purchase Price |
$10,000
|
$10,000
|
$10,000
|
| Sale Proceeds |
$15,000
|
$8,500
|
$4,000
|
| Return on Put Warrant |
50%
|
(15)%
|
(60)%
|
| Return on Share Investment |
(10)%
|
0%
|
10%
|
When the share price decreased $1.00 (from $10.00 to $9.00), the warrant provided a 50% return to the warrant holder while the share holder sustained a 10% loss. This illustrates how an investor can profit from share price falls by holding put warrants.
Back to top
Exercise Price
The exercise price (or strike price) is the second most important determinant of a warrant price and works in the opposite direction to the underlying price. For example, the higher the strike price of a call, the lower the value of the warrant. This is easily understood as the higher the price at which you are able to purchase the asset for at a future date (in the case of a call) the less likely the warrant is to be exercised and the less value that would be ascribed to that call.Conversely, the higher the price at which you are able to sell the asset for at a future date (in the case of a put) the more likely the warrant is to be exercised and the higher value that would be ascribed to that put.
Time to expiry
The greater the time to expiry, the greater the time value of the warrant. This is because the warrant has more time to perform or move into-the-money.
The time value of warrants can be expected to gradually decline in value to zero over the life of the warrants. This gradual decline in the time value is effectively part of the daily cost of holding a warrant.
An alternative way of understanding time decay for warrants is to consider it as equivalent to the daily decay of an insurance policy. The policy falls in value each day it approaches its expiry date because the period of insurance is decreasing.
Similarly the opportunity for the warrant to move into-the-money is decreasing and therefore the warrant value will decrease. In our hypothetical examples above, time decay is responsible for a 15 percent decrease in the warrant price when there is no change in the share price over the three month investment period. While the intrinsic value has remained unchanged, the time value has decreased to produce an overall decline in the warrant price.
Back to top
Dividends
Investors in warrants do not receive the dividends paid on the underlying shares, nor or do they directly participate in special dividends, rights or bonus issues. In valuing warrants, issuers estimate the expected dividend stream of the underlying shares. This means that call warrants should not fall in price when the underlying share trades ex-dividend (if the share price falls by the amount of the forecast dividend on the ex-dividend date). Similarly, put warrants should not substantially increase in price (if the share price falls by the amount of the forecast dividend on the ex-dividend date). Warrant prices can however be effected by a change to 'expected' dividends.
Volatility
Volatility can be defined as “a measure of uncertainty about the future returns provided by a stock”. The more uncertain the returns of a stock, the more volatile the share price will be. The more volatile the share price, the higher the risk and the higher the price of the warrant.
Implied volatility is incorporated into a warrant pricing model. It is represented as a percentage and typically ranges between 20-60% for singe stock warrants in Singapore. The level of implied volatility can change frequently, sometimes daily and will effect the price of a warrant. The higher the implied volatility the higher the price of the warrant.
Interest Rates
For each call warrant issued, issuers allocate funds to purchase underlying shares. If the cost of borrowing (ie. the interest rate) increases, the cost will be reflected in a corresponding increase in the warrant price.
Similarly, a put warrant will decrease in value when interest rates rise.
Important note: Warrants derive their value from an underlying asset, usually a share price or an index. However, there are a number of factors that determine the price of a warrant as detailed above. While returns from investing in warrants may outperform returns on shares, warrants are considered higher risk..
Back to top