Thursday 16 July 2009

Pricing of Warrants

The most important factor influencing the market price of a warrant is the relationship between the price of the underlying common stock and the price at which the investor may buy shares - the exercise price.

The warrant is in-the-money: stock price > exercise price
The warrant is out-of-the money: stock price < exercise price.

When the warrant is in-the-money, it has intrinsic value.

Minimum, maximum and actual market values of a warrant.

If it takes one warrant to buy one shae of stock, then the effective exercise price is the same as the stated exercise price.

If however, a single warrant with an exercise price of $10 allows you to buy 2 shares of a stock, the effective exercise price is $5.

Effective exercise price = Exercise price/conversion ratio

As Standard & Poor's warns, "trading terms and basis should be checked in detail." An investor should always check the effective exercise price, which is the stated exercise price divided by the conversion ratio. It is the amount of money needed to buy one share of the stock.

Assuming a conversion ratio of 1:1, it would not make sense for the warrant to ever sell for more than the value of the underlying asset. The theoretical maximum price of a warrant is therefore equal to the stock price. (For instance, if one share of the stock sells for $25, no rational person would be willing to pay more than $25 for the right to buy a share, even if the warrant exercise price were zero.)

The theoretical minimum value is the warrant's intrinsic value. This is the greater of zero and the amount by which the stock price exceeds the exercise price. (Given a stock price of $25 and an exercise price of $20, this warrant should always sell for at least $5. If not, arbitrage would be present.)

Actual warrant prices fall between the two extremes. The gap between the market price of the warrant and its minimum value is largest when the stock price equals the exercise price. As the stock price rises or falls from this point, the gap narrows.

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