## Wednesday, 16 September 2015

### Warrants: Premium

Premium is a measure of how much the underlying price has to move for the warrant to break even if it is held until maturity.

The premium for a call warrant

= [Strike Price + (Warrant Price x Conversion Ratio) - Underlying Price] x 100% / Underlying Price

(1)  Cost of buying a warrant = Warrant Price x Conversion Ratio
(2)  Breakeven point of the warrant = Strike Price  + Cost of component
(3)  Premium = [(Breakeven point of warrant - Underlying Price ) / Underlying Price]  x 100%

In this formula, we first calculate the difference between the breakeven point and the underlying price and then divided it by the underlying price to find out the premium as a percentage.

Likewise, the premium for a put warrant

= {Underlying Price - [Strike Price - (Warrant Price x Conversion Ratio)]} x 100% / Underlying Price

For example:

Company ABC Call Warrant currently trading at \$0.54, with a strike price of \$12 and a conversion ratio of 5:1.  If the underlying price is \$14, how much is the premium?

Cost of buying the warrant = \$0.54 x 5 = \$2.70
Breakeven point = Strike Price + Cost = \$12 + \$2.70 = \$14.70
Underlying price = \$14.00
Difference between Underlying price and Breakeven point = \$14.70 - \$14,00 = \$0.70
Premium = (\$0.70/\$14.00) x 100%  = 5%.

In other words, if the investor intends to hold the warrant until maturity, it takes a 5% increase in the underlying price from its current level of \$14 to breakeven.

In this example, what we have is an out-of-the-money (OTM) warrant, and the underlying must make a bigger climb to reach the breakeven point.

In the case of an in-the-money (ITM) warrant, a modest increase in the underlying price would be enough.

Summary:

Step 1:   First, calculate the breakeven point of the warrant. This is done by using the formula:  [(price of warrant x conversion ratio) + strike price]

Step 2:  Work out the difference between the breakeven point and underlying price and divide this by the underlying price to get the premium in percentages.

The premium only measures the percentage increase in the underlying price that will allow the warrant investor to break even upon maturity.

It does not tell us whether the price of a warrant is too high or too low.

Hence, unless you are prepared to hold the warrant until maturity, premium is not a relevant indicator for you.