A puzzle for investors might be how a warrant price is actually arrived at, because the forces of supply and demand take a back seat. Ordinarily, for equities and for traditional listed warrants, the price is purely a function of the demand from buyers and the supply from sellers.
For covered warrants it is different. The issuer will usually be the sole market-maker (or committed principal), who is obliged to make a two-way price in the warrant throughout the trading day. And supply and demand are, most of the time, only tangential factors in setting the price. Instead computers use algorithms to move the price automatically in relation to the changes in the underlying asset. There are too many warrants to price manually, and because covered warrants are a synthetic creation there is no need to balance supply and demand because the quantity in the market is more fluid.
Perhaps alarm bells are ringing? What is to stop the issuer from fixing the price to the detriment of investors? What is to stop the issuer from widening the dealing spread to prevent sensible dealing during times of financial stress? And how are the prices really determined?
The single market-maker model, where only the issuer makes a price in its warrants, is a tried and tested approach in overseas warrants markets, and it works well without abuse. Competition is not absent: far from it. It is simply that the competition occurs across warrants rather than within each individual security.
It is also reputational. On a popular security, warrants may be issued by several issuers, all competing for business. If one has a price which is less favourable than the others, it will very quickly become apparent in the market – good sources of electronic information make the process of comparison quick and efficient – and that issuer will lose out on trade.
The twin forces of inter-warrant competition and reputation work to ensure an orderly and fairly-priced market for investors.
Price Influences
In deciding what the fair price is, the issuer will take a number of factors into account in the pricing model. Price determination is a sophisticated process which is largely undertaken using algebraic techniques and computer models. The five principal inputs are the asset price, volatility, time to expiry, dividend yields, and interest rates.
| Influence on warrant price | Impact of rise in factor on warrant price | Impact of fall in factor on warrant price |
|---|---|---|
| Asset price | Rise (calls); fall (puts) | Fall (calls); rise (puts) |
| Volatility | Rise | Fall |
| Time to expiry | Rise | Fall |
| Dividend yields | Fall (calls); rise (puts) | Rise (calls); fall (puts) |
| Interest rates | Rise (calls); fall (puts) | Fall (calls); rise (puts) |
The most important, but not the only, determinant will be the underlying asset price, which for call warrants will push the price of the warrants higher as the asset rises – they will move in the same direction, other things being equal. For put warrants the prices should move in opposite directions.
Bid-only Warrants and Offer-only Warrants
Covered warrants will normally have a bid (selling) price and an offer (buying) price, but there may be occasions when warrants become either bid-only or offer-only. Warrants can become bid-only, or unavailable for buying, when a particular issue has become very popular and the entire tranche issued has sold out.
In these circumstances, the issuer, still keen to transact the business, will commonly issue another tranche of warrants with the same or similar terms. Sometimes this will not be desirable, however, if the time remaining is short, or if the market price has moved substantially so that the exercise price is no longer appropriate for a new issue.
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