How warrants are valued

The price of a warrant ultimately is determined by market forces. However, it is important to have some understanding of the various influences on warrant prices.

How the warrant is priced will depend on the type of warrant.  The following information is predominantly used to explain how trading warrants are valued. However, some aspects can be used to illustrate how instalments and other types of warrants are priced.

The market value of a warrant can be divided into two components - intrinsic value and time value.

Intrinsic value

Intrinsic value is the difference between the exercise price of the warrant and the current price of the underlying asset. It is always greater than or equal to zero.

If a warrant has intrinsic value, it is said to be ‘in-the-money’.

Warrants are also referred to as at-the-money or out-of-the-money, depending on where the current asset price is in relation to the warrant’s exercise price.

  Exercise price < asset price Exercise price = asset price Exercise price > asset price
Call warrant in-the-money at-the-money out-of-the-money
Put warrant out-of-the-money at-the-money in-the-money

Time value

Time value can be considered as the value of the continuing exposure to the movement in the underlying security that the warrant provides.

Time value is heavily influenced by whether the warrant is in-the-money, at-the-money or out-of-the-money. It will be greatest when the warrant is at-the-money.

Time value declines as the expiry of the warrant draws closer. This erosion of time value is called time decay. It is not constant, but increases rapidly towards expiry.

A warrant’s time value is affected by the following factors:

Time to expiry

The longer the time to expiry, the greater the time value of the warrant.

Volatility

The more volatile the underlying instrument, the higher the price of the warrant will be, all other things being equal.

This is because the price of the underlying asset has a greater probability of moving above (for a call) or below (for a put) the exercise price of the warrant, which makes the warrant more valuable.

Interest rates

An increase in interest rates will lead to more expensive call warrants and cheaper put warrants, all else being equal.

This reflects the cost of funding the underlying asset. By buying a call warrant you can defer paying for the underlying asset until the warrant’s expiry date, and invest the funds elsewhere during this period. As interest rates rise, more interest can be earned on the funds, so the call warrant is worth more to you.

The effect of an interest rate rise is the opposite for put warrants, as you are deferring the receipt, rather than the expenditure of funds.

Dividends

The effect of dividend payments varies depending on the type of warrant, and any entitlement of the warrant holder to receive dividends paid on the underlying asset.

Generally, if a dividend is payable during the life of a warrant, the cost of a call warrant will be lower, and the cost of a put warrant higher, compared to if no dividend was payable.

However, it is also relevant to consider whether the warrant is American or European in exercise style.

Furthermore, some warrants entitle the warrant holder to dividends paid on the underlying shares, which will significantly affect the warrant’s price.

You should ask your accredited derivatives adviser about the impact of dividends on a particular warrant.

Other influences

Other non quantifiable factors such as supply and demand, investor sentiment, and general market expectations can also influence the market value of a warrant. The warrant price may be influenced by the issuer's ability to offset his risk by buying or selling the underlying asset or another derivative.

For more information about which models are used to evaluate warrants, refer to the Pricing Models section.