Warrant
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Stock Warrant Definition and Valuation
FinPricing provides valuation models for the following warrants and rights:
- European Warrant
- American Warrant
- Call Warrant
- Callable Warrant
- Check FinPricing valuation models
| 1. Stock Warrant Introduction |
A warrant gives the holder the right to purchase shares at a fixed price from the firm. It is an option on the common stock of a firm issued by the same firm. The number of warrants outstanding is determined by the size of the original issue and changes only when they are exercised or when they expire.
Executive stock options are a form of remuneration issued by a company to its executives. They are usually at the money when issued. When options are exercised the company issues more stock and sells it to the option holder for the strike price.
The issuer settles up with the holder when a warrant is exercised. When a warrant or executive stock option is exercised new stock is issued by the company. In other words, when call warrants or executive stock options are issued by a corporation on its own stock, exercise will lead to new stock being issued.
Warrants give the small investor an opportunity to be exposed to expensive shares without having to buy 100 of the physical shares. Normally 10 warrants represent an exposure on 1 share and 100 warrants will thus cost much less than 100 shares. A warrant is a long call or put option on a share or a basket of shares and it will be discussed in detail in the chapter on options.
Warrants are in many ways similar to options, but a few key differences distinguish them.
Warrants and employee stock options are different from regular call options in that exercise leads to the company issuing more shares and then selling them to the option holder for the strike price. As the strike price is less than the market price, this dilutes the interest of the existing shareholders.
Warrants tend to have longer durations than do exchange-traded equity options. They are traded over the counter more often than on an exchange. Investors cannot write warrants like they can options.
Warrants do not pay dividends or come with voting rights. When warrants are exercised, the company typically issues new shares at the exercise price to fill the order. The resulting increase in shares outstanding dilutes the share value.
Investors are attracted to warrants as a means of leveraging their positions in a security. Warrants provide investors a way to hedge risk or speculate. They can be used to exploiting arbitrage opportunities.
| 2. Different Types of Warrants |
Warrants frequently attached to fixed rate bonds or preferred stock as a sweetener can be used to enhance the yield of the fixed rate bond and make them more attractive to potential buyers. Most commonly issued warrants are often detachable, meaning that they can be separated from the fixed rate bond and sold on the secondary market before expiration.
A detached warrant is a warrant that was attached to a bond and is sill quoted in bond units - a percent of par. The strike of the detached warrant is calculated from the bond parameters.
Wedded or wedding warrants are not detachable. The investor must surrender the fixed rate bond
or preferred stock the warrant is “wedded” to in order to exercise it. Naked warrants
are issued on their own, without accompanying fixed rate bonds or preferred stock.
A payout protected warrant is a warrant whose strike and share ratio are adjusted to protect the security from dividend fluctuations. The strike is adjusted according to actual dividends. The strike adjustment preserves the moneyness of the option therefore.
| 3. Warrant Payoffs |
If there were m outstanding shares and n outstanding warrants exercised, the dilution factor corresponding to the percentage
of the firm value that is represented by the warrants is given by
α = m / (m + n)
The payoff of the warrant at maturity T is given by
| 4. Warrant Valuation |
Warrants can be categored into three categories: European, American, and Callable/Call:
A European warrants can only be exercised on the expiration date. European warrants can be valued by the diluted Black-Scholes model and some modifications must be made to the parameters.
An American warrant allows the warrant holder to exercise their right to buy or sell the underlying on any date until expiry. The valuation of an American warrant is more complex. There is no closed form solution. One needs to use numeric approach to price it.
| 5. Callable Warrant |
A Callable warrant or call warrant gives the writer the right to recall/terminate the warrant on pre-determined dates for a pre-determined price. This callable (call) feature allows the writer to limit the warrant buyer's profit by activating an embedded call feature so as the position is closed out before the maturity.
Callable warrants or call warrants typically have contractual restaints that limit issuing firms' options. For instance, an issuer can force the warrant to exercise on or after a future date, in event that stock price has been in excess of a threhold (usually 150% of exercise price) on any 20 trading days within a period of 30 consecutive trading days.
There is no closed form solution for callable warrants or call warrants, one has to reach for numerical approaches, such as PDE or Monte-Carlo.
| 6. Warrant Example |
Here is an example of Warrant trade:
| Name | Value |
|---|---|
| Type | European |
| Strike | 10.8 |
| Issue Date | 3/19/2020 |
| Maturity Date | 3/19/2025 |
| Maturity Settlement Date | 3/20/2025 |
| Outstanding Shares | 1000000 |
| Number of Warrants Issued | 100000 |
| Trade Amount | 500 |
| Settle Currency | USD |
| Underlying | XXX |