Generally, there are five major factors that influence the price of a warrant, as shown in the following chart:

If you feel that tracking 5 factors is very complicated, you may take comfort in the fact that only 3 of these factors make a big difference in the warrant price most of the time whilst the other 2 factors can be left aside except under exceptional circumstances.

The 3 important factors are:

(1.1) Time Decay

(1.2) Spot Level

(1.3) Implied Volatility

The 2 minor factors are:

(2.1) Interest Rate Level

(2.2) Dividends

Major Factors:

(1.1) Time Decay: The Price of Gearing

Consider the following 2 call warrants:

Warrant A:

Underlying Stock = ABC Co. with current share price at $100

Strike Price = $100

Maturity = 3 months

Warrant B:

Underlying Stock = ABC Co. with current share price at $100

Strike Price = $100

Maturity = 6 months

Both warrants are based on the same stock and have the same strike price of $100. The only difference is that Warrant B has a longer expiry date, 6 months versus 3 months. Which warrant is worth more? Warrant B would of course be worth more since Warrant B has a longer time to expiry giving the underlying stock more time to rise above the strike price of $100 and enable investors to reap profits.

This comparison implies that the longer the time to expiry the more a warrant is worth. This is known as the "Time Value" of the warrant. As long as a warrant still has some time until maturity, it is worth some money since there is still a chance that the underlying stock or index can move into the money.

It then goes to say that as a warrant gets closer to the expiry date, it will lose "Time Value" since there is less and less time for the underlying spot to go into the money. This is known as "Time Decay". The diagram below highlights this point graphically by depicting the "Time Decay" of Warrant A if the underlying stock ABC Co. remains at $100 throughout its 3 month life.

First, notice that the cost of Warrant A, $6.73, is entirely composed of time value since the strike price is equal to the stock price. In other words, if Warrant A were to expire whilst ABC Co. remained at $100, Warrant A would be worthless. We keep the underlying stock price constant to show the second point.

Second, notice that Warrant A loses a bit of money everyday until it goes to zero at expiry. This is the "Time Decay" (or technically the "Theta") of the warrant. It is a predictable decay in the price of a warrant which can be calculated using standard options formulae. Therefore, the longer one holds a warrant, the higher will be the time decay of the warrant.

"Time Decay" is in fact inevitable for the warrant buyer. It can be viewed as the flipside or the cost of the high gearing provided by warrants. The good thing about time decay is that it is predictable and uniform, and therefore it holds no surprises for the warrant buyer.

(1.2) Spot Level

Spot Price: In-The-Money, At-The-Money and Out-of-The-Money

The movement of the underlying asset is a major factor affecting the price of warrants. Obviously, a rise in the underlying spot will benefit call warrantholders and a fall will benefit put warrantholders. What is less understood however is the terminology used in describing warrants of different strike prices in relation to the underlying spot price.

The first thing to understand is the concept of Intrinsic Value versus Time Value:

Intrinsic Value, for a call warrant, is the difference between the underlying spot price and the strike price. This represents the actual value of the call warrant if it expires today. In other words, the intrinsic value is the amount which the warrantholder will get back should it expire today. In our example, the call warrant represented by the faded block has a strike price of $90, whilst the underlying spot is trading at $100. If the call warrant expires at this level or the call warrant is exercised, the call warrantholder will get $10 ($100 - $90). Hence, we call the warrant an “In-The-Money” (ITM) warrant since it is making money on expiry. The same is true for a put warrant if the strike is above the underlying spot price.

Aside from intrinsic value, a warrant also has Time Value. This concept had been explained in the previous section. The most important thing a warrantholder has to keep in mind is that the time value of a warrant erodes with time until the warrant only contains intrinsic value on expiry.

The below diagram describes the difference between the Intrinsic Value and the Time Value graphically using a call warrant with a strike price of $90 whilst the underlying spot is trading at $100. You will see that the call warrant is worth at least $10.00 since one can exercise the warrant and buy the underlying stock at $90 and sell at the market at $100. But since the call warrant has not yet expired, there is still time value left which is represented by the $3.12. If the spot level stays at $100 by the expiry date then the call warrant will only be worth a maximum of $10, the intrinsic value.

With the concept of intrinsic and time value in mind, we can now go on to classify different types of warrants as either:

In-The-Money (ITM)

At-The-Money (ATM)

Out-of-The-Money (OTM)

In-The-Money and Deep In-The-Money

In-The-Money: as the term implies, in-the-money describes a warrant which has intrinsic value. For call warrants, this means that the current price of the underlying spot is higher than the strike price and for put warrants this means that the underlying spot is lower than the strike price. Hence, should the warrant expire immediately or allowed to be exercised, it would be worth money.

At-The-Money

At-The-Money (ATM) warrants are warrants that have a strike price which is the same or similar to the underlying spot price.

Out-of-The-Money & Far Out-of-The-Money

Out-of-The-Money (OTM) warrants are warrants which have a strike price that is above the underlying spot price for call warrants and vice versa for put warrants.

(1.3) Implied Volatility

The Art of the Game

Volatility is probably the least understood concepts for many warrant investors.

So what is volatility? There are two types of volatility: Historical Volatility and Implied Volatility.

Historical Volatility

Basically, historical volatility is a measure of the frequency and intensity of price change of the underlying asset (a stock or an index) on which a warrant is based. It is an annualised statistic, which represents a one-degree standard deviation price change, in percentage terms, at the end of a period. Don't let the obtruse statistical definition turn you off. Understanding volatility is basically very easy.

For example, if we say that an underlying stock A is currently trading at $100 and has an annual volatility of 10%, what does it mean? It means that according to past data we can expect the stock to be trading between $90 and $110 about 68% of the time within a year. Therefore if we say that another stock B is trading at $100 but has an annual volatility of 20%, you could presume that it would be trading between $80 and $120 about 68% of the time. Since stock B has a volatility of 20%, this means that it will have a greater variability of returns than stock A. In other words, stock B is more volatile.

Implied Volatility and Warrant Price

Apart from the underlying price, the most important factor that affects the price of a warrant is implied volatility. It is the expected volatility of the underlying in a given future period of time, and is positively related to the warrant price. When the implied volatility of a warrant increases, its price may go up. When the implied volatility decreases, the warrant price may go down.

Let us look at a simple example. Say, Stock A is currently trading at S$10. The market expects that the range of fluctuations of the stock will be within S$1 for most of the time in the future. So, what is the probability that Stock A will climb to S$20 within 6 months? Then there is Stock B also currently trading at S$10, and the market expects that its range of fluctuations will be within $5 for most of the time in the future. Now, which one, between Stock A and Stock B, will have a better chance of hitting S$20 in 6 months? Obviously, the answer is Stock B.

Given that the final value of a warrant is determined by the difference between the underlying price and the strike price on maturity. The higher the expected volatility of the underlying, the higher the issue price of the warrant will be. The reason is that in such a case, there is a higher probability for the underlying price to go above (in the case of a call warrant) or below (in the case of a put warrant) the strike price.

If, for some reason, the market expects a drop in the volatility of Stock B (say, from S$10 to S$1 in terms of the range of fluctuations) in a given period of time, then the price of a related warrant may go down as well. This is due to the lower probability that the price of Stock B will exceed the strike price of the warrant upon maturity. Hence, there is less chance for the warrant to be exercised upon maturity, and the investor will also have a less chance to get a higher return. As a result, the warrant price is likely to fall.

Minor Factors that You Should Know About: Dividends and Interest Rates

Dividends and Interest Rates also affect the price of warrants but to a much lesser degree:

(2.1) Dividends

The dividend payment by itself does not affect the theoretical price of the warrant since it has already been taken into account in the price of the warrant by the Issuer.

Only an unexpected change in the amount of the forecasted dividend during the life of a warrant will have an impact on its price after it is issued. In general, dividends are a minor factor compared to other parameters like implied volatility and spot level since expected dividend levels usually do not change very signigicantly.

(2.2) Interest Rates

Rising interest rates are positive for Call Warrants and negative for Put Warrants:

Nevertheless, interest rates movements normally have limited impact on warrant prices compared to other parameters like implied volatility, spot level and time decay. Only during exceptional or critical circumstances when interest rates deviate significantly from their norms will they play a significant factor in warrant valuation. Warrant investors therefore generally tend to ignore this factor.

In Summary

Warrant prices are subject to 5 pricing factors as shown below. Note that the first 3 factors are more significant factor than the last 2 which only have material impact on warrant prices under exceptional circumstances.