A warrant gives the investor the right to buy or sell the underlying asset at a pre-determined price on (European warrant) or before (American warrant) a predetermined date. The underlying asset can be stock, index, currency, commodity or something else. Since the warrant derived its value from its underlying, it is known as a derivative instrument.
- Warrants give you a right but not obligation
- A warrant’s value is mainly affected by the underlying price
- The longer the maturity, the higher the value of a warrant
- The more volatile the underlying price, the higher the value of a warrant
Warrants give you a right but not obligation
Suppose you want to buy a 3-room apartment flat currently worth S$200 000 (that must be a very good location flat), and the investor has the right to it at S$250 000 one year later. With the inflation hike and the booming real estate market, the 3-room apartment is most likely to appreciate to S$300 000 one year later. In order to have the right of buying the 3-room apartment at S$250 000 one year later, the investor has to pay S$20 000 for it. Assuming one year later, the 3-room apartment appreciate to S$310 000, the investor holding the warrant now has the right to exercise the right and buy the apartment at only S$250 000. That is, the investor profit S$40 000 (S$310 000 – S$250 000 – S$20 000) straight away. However, if the apartment price rise to S$210 000 or drops to S$192 000, then it makes no sense for the investor to exercise the right as he or she can get the apartment at a cheaper price than to pay S$250 000 for it. In this scenario, the investor will suffer a loss of S$20 000.
A warrant’s value is mainly affected by the underlying price
Suppose you hold the right to purchase the apartment at exercise price of S$250 000 by paying S$20 000 for it. The value of this right is, naturally, mainly determined by the market price of the apartment (of course there are other factors as well). If the apartment is worth S$310 000, the value of the right will be S$60 000 (ignoring the amount you paid for the right). Yet if the price of the apartment falls to S$192 000, the right will become worthless, because it cannot be exchanged for any value. Hence the difference between the market value of the apartment and the strike or exercise price of the right to purchase determines the “intrinsic value” of the latter.
The longer the maturity, the higher the value of a warrant
If you are given another right to purchase the same apartment at exercise price of S$250 000 but two years later, which warrant will fetch a higher price?
Obviously, the current one will fetch a higher price. This is because it is much more likely for the property to rise above S$250 000 in two years than one year assuming the real estate market is still blooming. Hence the more likely the right will be exercised the more valuable it is. Or we can say this current warrant is more valuable than the original one because of its higher “time value”. You are able to resell the right to another buyer for a higher price if the property price is expected to skyrocket after one year or even a couple of months. Accordingly, the longer the maturity, the more valuable the right will be.
The more volatile the underlying price, the higher the value of a warrant
Now suppose you have a choice of two apartments, both worth S$200 000 now. Suppose one is located near Orchard road and the other one is located in Tuas (quite unlikely, but just example ok). You may find that from time to time, most probably the price of the apartment at Orchard will goes up and down and as you may guess, the apartment in Tuas will most probably not fluctuate much, if not, not at all. Once again, if you were to buy the warrant, which one will, you choose most likely? Well, I suppose you will choose to buy the warrant for the apartment located at Orchard road. It is because the apartment at Tuas is quite unlikely to rise further in price in one year time. In contrast, the one at Orchard road will most probably fetch a better price and may well appreciate to beyond S$250 000 in a year time. This means that the warrant for the apartment at Orchard road will be more valuable.
I’ll be posting more about warrants in my coming posts. Lastly, I would like to wish all my readers a Merry Christmas and Happy New year.