WARRANTS (SECURITIES)



Warrants are options to purchase a fixed number of shares for a fixed price, known as the warrant-conversion price. Warrants typically have an expiration date, although some are issued in perpetuity. Warrants may be sold either with a bond or stock issue. If the underlying stock price rises substantially, the warrant holder can exercise the warrants at the fixed price and participate in the stock's growth. When issued with bonds, warrants reduce the bonds' coupon rate. Warrants are typically issued to entice investors with a no-risk opportunity to participate in future growth.

The intrinsic value of a warrant is equal to the market price of one share of common stock, minus the exercise price of the warrant, times the number of shares that can be purchased with each warrant. If the current market price per share of common stock is $ 10 and the warrant exercise price is $2, and if each warrant allows the investor to purchase two shares, the warrant has an intrinsic value of $16.

The actual market value of a warrant may be higher than the intrinsic value. The difference between the market value and the intrinsic value is the premium. The market value of the warrant can never be less than zero. The premium depends on the warrant's leverage effect, the time to maturity, and the volatility of the price of the underlying stock. The warrant's leverage depends on the difference between the market price of the underlying stock and the warrant exercise price; the greater the difference in price, the higher the leverage and the greater the potential for gain or loss. The longer the time to maturity, the higher the premium, because the probability that the underlying stock will increase in price is greater. The greater the volatility of the underlying stock, the higher the premium, again because the probability that the underlying stock will increase in price is greater.

The warrant premium is a negative function of the cash dividend paid on the underlying stock. Since the owner of the warrant does not own the underlying stock, he/she is not entitled to the cash dividend paid. The larger the dividend that is paid on the underlying stock, the lower the premium on the warrant.

Some restrictions may apply to stock acquired through warrants. In the case of ordinary warrants, the Securities and Exchange Commission (SEC) requires investors who have exercised warrants to delay selling their stock until the expiration of a holding period-usually two years. To bypass this restriction companies began issuing net-issuance warrants, in which no cash is exchanged when the warrants are exercised. If the net-issuance warrant entitled an investor to purchase $5,000 worth of stock at a $2,000 warrant-conversion price, the company would subtract the cost of the conversion and issue $3,000 worth of stock to the investor.

[ Carl B. McGowan , Jr. ,

updated by David P. Bianco ]

FURTHER READING:

Carlsen, Clifford. "Document Uses Warrants as Lure in Stock Offering," San Francisco Business Times, I November 1991.

Ehrhardt, Michael C., and Ronald E. Shrieves. "The Impact of Warrants and Convertible Securities on the Systematic Risk of Common Equity," The Financial Review, November 1995.

McHattie, Andrew. The Investor's Guide to Warrants: Capitulize on the Fastest Growing Sector of the Markets. Financial Times Management, 1996.

Reilly, Frank K., and Keith C. Brown. Investment Analysis and Portfolio Management. 5th ed. Fort Worth, TX: Dryden Press, 1996.

Spiro, Herbert T. Finance for the Nonfinancial Manager. 4th ed. New York: John Wiley & Sons, 1996.



User Contributions:

Comment about this article, ask questions, or add new information about this topic:

CAPTCHA