Warrants

Introduction

Since Malaysia's first warrant appeared in 1990, this derivative has gained popularity. The following is only a brief guide on trading in warrants. Subscribers of i Capital® are encouraged to conduct their own research to fully understand this volatile investment.

What is a warrant?

A warrant is a right to buy a share of a firm at a certain price during a given time period. A warrant can be exercised ( converted to an ordinary share ) at any point within this given time period.

Why does a company issue warrants?

Warrants are often offered as “sweeteners” in a loan stock/bond/rights issue. In the case of a bond/loan stock issue, a warrant may give the company a lower interest payable on the issued debt.

How do you put a price on a warrant?

A warrant has 2 values : intrinsic value and time value. Its intrinsic value is the difference between the current price of the underlying stock and the warrant's exercise price. Factors that positively affect a warrant's time value are the expected volatility of the underlying stock and the warrant's time to expiration. Other factors to be taken into account are expected dividends from the underlying equity and market sentiment.

Ratios and pricing models.

Ratios help investors judge if a warrant is priced fairly. By looking at them, investors are able to value a warrant relative to its historical pattern and other warrants. Common ratios used are: premium, gearing, parity and equity appreciation to double warrant. Pricing model put a theoretical value on a warrant, taking into account factors such as the volatility of the underlying share and many others. Two popular pricing models are the Black - Scholes and Binomial option pricing theory. These models are dependent on the efficiency of the market to reflect their underlying assumptions; hence they may not be precise when estimating the price of a warrant on the KLSE.

Relationship between a warrant and its stock

Where the issuance of warrants in itself does not change the value of the firm, the issuance of warrants does have a direct effect on the share price of the firm. This relationship can be shown with the following equation :- 

P = PX - qW

where
P = the new price of the share
W = the value of the warrant
q = number of warrants / number of shares
PX = the old price of the share

Should I buy warrants?

Two factors should be considered before purchasing warrants. First, the investor must be confident of the underlying share. Secondly, the warrant must be attractively priced based on relative valuation (ratios) and / or pricing model.

AN EXAMPLE

Company XYZ

Market Price of Equity $5.55 (A)
Market Price of Warrant $2.83 (B)
Exercise Price of Warrants $3.80 (C)

Equivalent Price $6.63 (B + C)
Parity Ratio 1.46 (A / C)
Premium 19.46% [(B+C)/A]
Gearing 1.96 (A/B)

Equity Appreciation to Double warrant 70.45%
[(2B+C)/A]-1

Once the above 2 factors have been taken into account, an investor might decide to purchase warrants to maximize his / her return from the equity market. Warrants are the best instrument to maximize gain when an investor is very bullish. They give investors a chance to participate in the movements of shares at a lower capital cost. However, the market for warrants is still small, hence warrants may be volatile and may be the target for artificial rallies. So buy warrants only if you like the underlying share and the warrant is fairly priced according to the ratios and pricing theories mentioned above.