Covered Warrants I

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20. Basic analysis V (premium)

In practice, warrants will not trade simply at their intrinsic value. Investors will be willing to pay extra for the benefits which warrants provide, most obviously the gearing. This extra amount is called the warrant’s time value – and is sometimes regarded as the warrant’s speculative value.

Time value is sometimes referred to as premium which is normally expressed as a percentage as follows:

For call warrants

Premium (%) =	(warrant price x cover ratio) + exercise price - asset price	x 100
	asset price

Example

asset price 80p, exercise price 100p, warrant price 2p, cover ratio 5:1.

Premium (%) =	(2p x 5p) + 100p - 80p	x 100
	80p

Premium = 37.50%

For put warrants

Premium (%) =	(warrant price x cover ratio) + asset price - exercise price	x 100
	asset price

Premium calculator Warrant price   p Cover ratio     Asset price   p Exercise price   p Call warrant    % Put warrant    %

In general, the lower the premium, the cheaper the warrant.

This is because the underlying asset must rise (or fall for puts) by a percentage equal to the premium over the remaining life of the warrants for the warrants to justify their current price. The reason the asset must move by this amount is that the premium will disappear over the remaining life of the warrant.

Warrant premiums

Time value
By definition the warrant is worth only its intrinsic value at expiry, which means the premium diminishes to zero as time passes.

The time value of a warrant

Break-Even Point

In view of the diminishing premium, the asset price must usually grow for a warrant purchaser to avoid a loss. It is a simple matter to calculate the point which the underlying asset needs to reach by the maturity date of the warrants for an investment to break even.

The break-even point is usually expressed as an annual required rate of change in the underlying asset. This annualised rate of change is useful for warrants with a life of one or two years, but is more difficult to interpret once the maturity drops to below a year. Its use might therefore be restricted on many occasions to new issues.

Break-even point calculator Exercise price   p Price paid   p Cover ratio     Call warrant      Put warrant

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

Recommend Reading

• Andrew McHattie on Covered Warrants

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