Warrants are certificates issued by RBS N.V. that give the investor the option to buy or sell a certain amount of an underlying at a specific price before or on a predetermined date.
Call Warrants enable investors to profit from rising market prices. Put Warrants enable investors to profit from falling market prices. Warrants are typically issued on shares, baskets of shares, commodities, foreign exchange, indices and bonds.
Advantages
- High yield potential
- Small initial investment
- Risk limited to a moderate initial investment
- Opportunity to hedge an existing portfolio
Price Behaviour
The market value of the Warrant at expiry should typically equal its intrinsic value. Generally, the value of a Call Warrant will increase as the price of the underlying security increases and the value of a Put Warrant will increase as the price of the underlying security decreases, all the other factors remaining constant.
Warrants are classified as American style if they can be exercised at any time during the life of the Warrant, or European style if they can only be exercised on the expiry date.
Call Warrant
Assumptions
A Call Warrant on share XYZ with a Strike price of EUR 10 will cost the investor EUR 1.50.
Intrinsic value is EUR 0 and time value is EUR 1.50.
Scenario 1
At maturity the share price of XYZ is EUR 15.
In this case the investor will exercise his Call Warrant. He will buy the share at the Strike price of EUR 10 and make a gain of EUR 5 for a cost of EUR 1.50.
In terms of return on investment (ROI), the EUR 1.50 paid for the Warrant gives the investor a gain of 233% (gain of EUR 3.50 relative to a EUR 1.50 investment). If the investor had purchased the share instead of the Call Warrant, he would have made a profit of EUR 5. The ROI from purchasing the underlying shares would only have been 50% (gain of EUR 5 relative to a EUR 10 investment).
Scenario 2
At maturity the share price of XYZ is EUR 5.
In this case, the holder of the Warrant will not exercise his Call Warrant. He will make a loss limited to the Warrant price, EUR 1.50.
If he had purchased a share instead of buying a Warrant, he would have incurred a loss of EUR 5.
Scenario 3
At maturity the share price of XYZ is EUR 9.
In this case, the holder of the Warrant will not exercise his Call Warrant. He will make a loss limited to the Warrant price, EUR 1.50.
If he had purchased a share instead of buying a Warrant, he would have incurred a loss of EUR 1.
Put Warrant
Assumptions
A Put Warrant on share XYZ with a Strike price of EUR 10 will cost the investor EUR 1.50.
Scenario 1
At maturity the share price of XYZ is EUR 7.
In this case, the investor will have the right to sell a share at EUR 10 resulting in a gain of EUR 3. In ROI terms (EUR 1.50 for the Warrant) the investor would have made a gain of 100%.
If he had short sold a share instead of buying the Warrant, he would have made a gain of EUR 3.
Scenario 2
At maturity the share price of XYZ is EUR 15.
In this case, the holder of the Warrant will not exercise his Put Warrant. He will make a loss limited to the Warrant price, EUR 1.50.
If he had short sold a share instead of buying a Warrant, he would have incurred a loss of EUR 5.
Scenario 3
At maturity the share price of XYZ is EUR 11.
In this case, the holder of the Warrant will not exercise his Put Warrant. He will make a loss limited to the Warrant price, EUR 1.50.
If he had short sold a share instead of buying a Warrant, he would have incurred a loss of EUR 1.
Risks
The price of a Warrant is made up of two components - the intrinsic value and the time value of the Warrant. The intrinsic value is the amount by which a Warrant is in the money. The intrinsic value of a Warrant is calculated in the following manner:
Intrinsic Value for a Call Warrant
Underlying security’s price - Strike price of Warrant
(Cannot be negative)
Intrinsic Value for a Put Warrant
Strike price of Warrant - Underlying security’s price
(Cannot be negative)
The time value is generally the difference between the price of the Warrant and its intrinsic value. If the Warrant has no intrinsic value, then the price of the Warrant is equal to the Warrant’s time value.
Parameters
The following two main variables determine the value of a Warrant:
Time to Maturity: the longer this time, the higher the time value.
Volatility: the measure calculating the price movement of the underlying. The higher the volatility, the higher the time value.
Risks
Warrants are highly leveraged investments, which means that buyers risk losing their entire invested capital. Investors should be aware that the price of Warrants can be volatile and that they experience time decay throughout their lifespan. The rate of this decay accelerates for Warrants near expiry and they can expire worthless. In the worst case, the investor can lose their entire investment.