23rd letter to friends of Brunei [Warrants (Part 1)]

A warrant gives its holder the option to buy a stock at a specified exercise price before an expiry date. After the expiry date, the warrant is worthless. We can understand warrant by contrasting with other similar product.

a. Compared to stock option, warrant has a longer life-span. Most stock options are less than a year, whilst it is common for a warrant to have a 5 or more years life-span.

b. Compared to stock future, warrant holder has no obligation to exercise option.

c. Compared to convertible bond, warrant does not pay coupon interest or a maturity value.

Warrant is usually issued as a sweeterner for a share or debt issue of a company. Its price, compared to convertible bond, is much lower. For example, Flextech, a once SGX-listed company, issued a warrant at $0.14, which allow the holder to buy the stock for $1.50 before 2 Oct 2022. At that time of issue, the stock price of Flextech was trading at $0.78.

Let's do some mathematics on warrant.

Assuming ABC company has a warrant trading at $4. The conversion ratio is 1:1 (i.e. 1 warrant can buy 1 stock of ABC Co.), and the exercise price is $5. ABC stock is now trading at $8.

1. Intrinsic Value of Warrant

Intrinsic value = [Stock price - Exercise price] / conversion ratio

Intrinsic value(ABC warrant) = [$8 - $5] / 1 = $3

It is possible that the stock price is trading below the exercise price. In this case, the intrinsic value is zero.

2. Speculative Value

Speculative value = warrant price - intrinsic value

Speculative value (ABC warrant) = $4 - $3 = $1

3. Conversion Value

Conversion value = Exercise price + (Warrant price x Conversion ratio)

Conversion value (ABC warrant) = $5 + ($4 x 1) = $9.

4. Warrant Premium

Warrant premium = Conversion value - stock price

Warrant premium (ABC warrant) = $9 - $8 = $1

5. Gearing (or leverage) Ratio

Gearing ratio shows for each dollar invested in the warrant, how many dollars of the stock it lays claim to:

Gearing ratio = Stock price / (warrant price x conversion ratio)

Gearing ratio (ABC warrant) = $8 / ($4 x 1) = 2 times

I.e. for every one dollar in ABC warrant, two dollars of the stock it lays claim to.