What it means
A warrant gives its holder the right to buy a company's shares at a fixed price, called the exercise price, before an expiry date. Investors buy warrants because they cost less than the shares themselves and can rise in value when the share price climbs.
To own the shares through a warrant, the investor pays the warrant price now and the exercise price later. The total is compared with the price of the share today, and the difference is the premium that the investor pays for using the warrant route.
The premium is made up of two things. Intrinsic value (the amount by which the share price exceeds the exercise price) is the first, and time value (what investors pay for the chance of further gains before expiry) is the second.
Investors use the premium to compare warrants and to judge whether one is expensive. A low premium suggests a warrant that behaves much like the shares, while a high premium suggests that much of the price is hope.
The premium usually shrinks as expiry approaches, because the time value falls to zero at the end. Holders should therefore be aware that a warrant can lose value even if the share price stays the same.
The premium also helps companies that issued the warrants. A high premium means holders are unlikely to exercise soon, because they would be better to sell the warrant than to convert it, which delays the cash the company receives and the new shares it must issue.
In practice
Real-world examples.
Example
An investor compares a warrant at $3 with an exercise price of $25 against buying the shares at $20 today. The premium of 40% tells her the shares must rise a long way before the warrant pays off, so she buys the shares instead.
Example
A fund manager looks at two warrants on the same company. One has a premium of 15% and the other 45%, and he chooses the first because it behaves more like the underlying share and costs less in time value. He also checks the expiry dates, because the longer warrant has more time value to lose.
Example
A company that issued warrants to investors monitors their market prices. A falling premium tells the finance team that the market has become less hopeful about the share price, which may affect how likely the warrants are to be exercised. The treasurer reports the figure to the board each quarter.
Formula
Calculation
Warrant premium = warrant price + exercise price - current share price
Premium percentage = warrant premium / current share price
Suppose a share trades at $20, a warrant allows the holder to buy it at $25, and the warrant costs $3. The effective cost of owning a share through the warrant is 3 + 25 = $28. The premium is 28 - 20 = $8, which as a percentage of the share price is 8 / 20 = 40%. The share must rise by more than 40% before expiry for the warrant holder to do better than someone who bought the share outright for $20.Case study
Seen in the real world.
Harbourview Energy is an illustrative, fictional company that issued warrants with a rights offering. Its shares traded at $12, the exercise price was $15 and the warrants traded at $2.
An analyst calculated the premium as 2 + 15 - 12 = $5, which is 5 / 12 = about 41.7% of the share price. She advised clients that the warrant offered strong leverage, meaning a small share price rise would produce a large percentage gain, but also that the high premium made it risky.
Six months later the share price had barely moved and the warrant had dropped to $1.20 as time value faded. The illustrative lesson is that warrants can lose value without any change in the share price, and the premium shows how much of that risk is built in. Harbourview's investor relations team now explains the premium to shareholders in plain terms.
Watch out
Common mistakes.
- Comparing only the warrant price with the share price, without adding the exercise price to the cost.
- Assuming a high premium is bad in every case, when it can reflect a long time to expiry and strong expectations.
- Forgetting that the premium falls as expiry approaches, so waiting can erode the value of the warrant, even when the share price stays still.
Questions
People also ask.
What is the difference between a warrant premium and an option premium?
An option premium is the price paid for the option, while the warrant premium here is the extra cost of owning the share through the warrant compared with buying the share itself.
Can a warrant premium be negative?
In theory, if the warrant is mispriced, but in practice markets quickly remove such gaps.
Why does the premium fall over time?
Because the time value of the warrant declines as expiry gets nearer, and it reaches zero on the last day.
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