Traditional corporate equity warrants

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7. Fundamentals - warrant terms

Warrant terms

Whenever a warrant is issued, there is supporting documentation detailing the subscription rights (also called the warrant terms). Most warrants are fairly similar, but they can differ on specific details. For that reason it is always very important to read carefully the warrant terms. An example of a warrant's terms is given below.

Each ABC plc warrant entitles the holder to subscribe for 1 Ordinary share in ABC plc at 100p during the 30 day period following dispatch of the Interim Statement or Report & Account until 2009.

There are a few features to always look out for in the warrant terms-

1. Underlying asset. This is the asset that the warrant-holder will receive on conversion of the warrant. For normal UK company warrants, this will be the company's shares itself. So, if ABC plc issues warrants, those warrants will normally convert into ABC plc shares. However, not all warrants are like this. Occasionally, warrants may be convertible into another company's shares; or, in the case of covered warrants, the warrants may be convertible into almost anything.
2. Conversion ratio. This details the number of shares that a warrant-holder will receive upon exercise of one warrant. Normally this will be one - in other words, one warrant converts into one share. Sometimes, though, one warrant converts into two, or more, shares.
3. Exercise price. Sometimes called the subscription price. The price that must be paid to exercise the warrant and receive the allotted shares. This is frequently 100p, but can be any price.
4. Exercise price currency. In the case of the vast majority of warrants listed on the LSE, this will simply be Sterling. However, there are also some funds listed on the LSE, incorporated overseas, that are traded in US Dollars. In these cases, the exercise price will be priced in Dollars as well.
5. Exercise dates. Describes exactly when the warrant may be exercised. In the example above, this is restricted to the 30-day period following the dispatch of the interim and final reports each year. This type of restriction is common. But other styles exist, including exercise on just one date a year, or exercise possible on any date.
6. Exercise period. The period over which the subscription rights are valid. In the case above, this is up to the year 2009. The average period for new issues is 5-7 years. This period is sometimes called the warrant's life or maturity. In October 2001, the average expiry date on warrants listed on the LSE was Feb 2005 (giving an average maturity of 3.33 years).

The range of terms listed above may at first seem rather bewildering. However, while it is important to be aware of the exact terms of a warrant, the great majority of them do have fairly standard terms. The flip side to this, of course, is that opportunities can occur amidst the complexity. For example, the fact that a warrant gives rights over four shares, and not one, may be missed by many investors. As such, the warrant investor, instead of being put off by confusing terms, should revel in detail and complexity!

While it is wise to be aware of the subscription rights of a warrant, do not be overly concerned about the actual mechanics of exercising warrants (explained later in the course). The theoretical subscription rights of a warrant are what imparts value to that warrant, but in practice, warrant are rarely actually exercised by individual investors.

Adjustment of subscription rights

Once issued, the terms of a warrant are broadly fixed. However, in certain circumstances, such as a capital issue (e.g. a rights or bonus issue), then the exercise price, and sometimes the conversion ratio, will be adjusted. The reason for this is to be fair to the warrant holders, who would otherwise miss out if the share price was adjusted down following a scrip issue.

The exact adjustment procedure will be detailed in the warrant terms, and can be rather complex. Briefly, the exercise price will be adjusted down, usually in proportion to the commensurate fall in the share price. If that was the only adjustment made, then the total value of an investor's warrant holding would fall as well. To compensate for this, either the number of shares each warrant converts into will be increased, or the warrant holder will receive a special issue of new warrants from the company.

Warrant pillar diagram

For the newcomer to warrants, it can be rather confusing trying to juggle in one's head all the elements involved. There's the price of the warrant, an exercise price and then also the price of the underlying shares. How do all these fit together? One way that can be helpful is to draw a simple diagram that represents the relationship between the major elements. To illustrate this, we'll look at the example warrant below.

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

The relationship between the warrant and underlying share can be represented (below) in what we will call a 'Pillar Diagram'.

A pillar diagram

There are two pillars in the above diagram, which represent the two different methods of acquiring shares in the company -

1. Directly. The left column represents buying shares directly in the shares market, where the shares' market price is 120p.
2. Via the warrant. The right column represents acquiring the shares by first buying the warrants (at 50p), and then exercising the warrants (by paying 100p to the company to receive one share).

In both cases, one ends up possessing one share in the company. Except that in case (1) one has paid 120p, and in case (2) one has paid a total of 150p.

Summary

Warrants can be a slippery subject! Just when you think you're getting on top of them, a new warrant will come along, with slightly different terms, and you're lost. But all warrants, however complex, can be represented by the simple pillar diagram. If you get into trouble, draw a sketch of the pillar diagram on a piece of paper. This should help understand the warrant.

We will be returning frequently to the pillar diagram in this course, so it will help to get thoroughly familiar with it at this stage. We will also be referring often to the intrinsic value of a warrant, so this 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