Traditional corporate equity warrants

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8. Fundamentals - intrinsic value and parity ratio

Intrinsic value

Recall that a warrant allows a warrant-holder to buy shares in a company at the exercise price. If a warrant's exercise price is 100p, and the underlying share price is 120p, this is a valuable feature of the warrant. And if the share price rises, while the exercise price is fixed at 100p, the warrant becomes ever more valuable. Exactly how much more valuable is measured by the intrinsic value, which is the simple difference between the share price and exercise price.

intrinsic value = share price - exercise price

In the warrant example,

ABC plc warrant
Share price: 120p
Exercise price: 100p
Warrant price: 50p

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

Equivalent options terminology

Note: for investors familiar with options, they will recognise that a positive intrinsic value equates to an option being termed in-the-money, while zero intrinsic value equates to an option with at-the-money or out-of-the-money.

Parity ratio

An alternative way of expressing the intrinsic value is the parity ratio, which is defined as -

parity ratio = share price / exercise price

Warrants with a parity ratio over 1.0 will be in-the-money, below 1.0 are out-of-the-money, and equal to one are said to be trading at parity (when the share price equals the exercise price).

Summary

We will be referring often to intrinsic value in this course, so it is a very important concept to understand.

1. Introduction 2. What is a warrant? 3. The warrant market 4. Advantages of warrants over shares - the magic of gearing 5. Further attractions of warrants 6. Disadvantages of warrants 7. Fundamentals - warrant terms 8. Fundamentals - intrinsic value and parity ratio 9. Basic analysis 10. Analysis - time value and premium 11. Analysis - gearing 12. Analysis - break-even and capital fulcrum point 13. Analysis -sample spreadsheets 14. Analysis - summary 15. Investing strategies 16. Dealing in warrants 17. Warrant exercise 18. Further topics 19. Further information 20. Conclusion

• Andrew McHattie on Covered Warrants