Covered Warrants I

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19. Basic analysis IV (intrinsic value)

A warrant price is always composed of two elements, the intrinsic value and the time value.

Warrant price = intrinsic value + time value

Intrinsic value is usually the first stop for any new investor because it is the most obvious measure of value. Even the least informed investor can see that a warrant carrying the right to buy one share at 100p will have a value of 50p if that share is trading at 150p. This is the intrinsic value: the value which a warrant would have if it were to be exercised immediately.

Calculation

For call warrants

Intrinsic value = asset price - exercise price

For put warrants

Intrinsic value = exercise price - asset price

These equations assume that one warrant carries the right to buy one share, which is not always the case for covered warrants. The equations are developed thus:

For call warrants

Intrinsic value =	asset price - exercise price
	cover ratio

For put warrants

Intrinsic value =	exercise price - asset price
	cover ratio

The intrinsic value can be illustrated in the pillar diagram below.

When the share price is 120p, and the exercise price is 100p, the intrinsic value of the warrant is said to be 20p. If the share price increased to 200p, the intrinsic value of the warrant would be 100p. However, if the share price fell to 100p, or below, the intrinsic value would fall to zero. This reflects that, at that time, there is no immediate value in exercising the warrant. Why, for example, exercise a warrant at 100p, if the market price of the shares is 80p?

A pillar diagram showing intrinsic value

Intrinsic value calculator Asset price     Exercise price         Call warrant      Put warrant

If a warrant has:

• positive intrinsic value: it is said to be in-the-money
• zero intrinsic value: at-the-money ( where the asset price is equal to the exercise price)
• negative intrinsic value: is out-of-the-money

Parity ratio

The degree of ‘moneyness’ is called the parity ratio.

A call warrant exercisable at 100p into an underlying share with a current price of 110p would have a parity ratio of 1.1, or 110%.

For call warrants

Parity ratio =	asset price
	exercise price

For put warrants

Parity ratio =	exercise price
	asset price

Parity ratio Asset price     Exercise price     Call warrants      Put warrants

The relative importance of intrinsic value

Recall from above that a warrant price is composed of two elements:

Warrant price = intrinsic value + time value

The fact that intrinsic value is a function purely of the share price and the exercise price, ignoring the actual warrant price, provides a clue that it is an incomplete measure of value. The second component of the warrant price – the premium – is usually more important for analytical purposes, and intrinsic value is unlikely to be a primary consideration unless you are a very cautious investor, market conditions are poor, or the warrant is close to final expiry.

Intrinsic value relates to the exercise value of a warrant, so it is most relevant when a warrant is bought with the intention of holding it to full term, which is not common in the covered warrants market.

1. Introduction 2. What are covered warrants? 3. Comparison between corporate warrants and covered warrants 4. Advantages of warrants 5. Advantages of warrants – the magic of gearing 6. Disadvantages of warrants 7. Advantages & disadvantages - a summary 8. International warrants markets 9. UK warrant market 10. Types of covered warrant I (warrant terms) 11. Types of covered warrant II (underlying assets) 12. Types of covered warrant III (exotics) 13. Information on warrant terms 14. Warrant trading 15. Warrant pricing 16. Basic analysis I (underlying asset) 17. Basic analysis II (prices and terms) 18. Basic analysis III (gearing) 19. Basic analysis IV (intrinsic value) 20. Basic analysis V (premium) 21. Advanced analysis I (Black-Scholes Model) 22. Advanced analysis II (volatility) 23. Advanced analysis III (the greeks) 24. Risk 25. Trading strategies 26. Tax 27. Conclusion

• Andrew McHattie on Covered Warrants