Prepaid Warrant – Definition

Cite this article as:"Prepaid Warrant – Definition," in The Business Professor, updated April 15, 2019, last accessed August 9, 2020, https://thebusinessprofessor.com/lesson/prepaid-warrant-definition/.

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Prepaid Warrant Definition

In finance a warrant is an authority that is given to an investor by a company to purchase its stock at a certain fixed price within a specific period of time regardless of the company’s stock valuation. The stock price offered by the issuing company – usually through a private placement – to the investor is called the exercise price or strike price.

Now, when a warrant is prepaid, it means that the investor has already deposited the exercise or strike price for the number of security allowed to be purchased from the company. So, when the investor will want to utilize the warrant at a later date, there will be no need for any additional financial consideration on the investor’s part.

Generally, the strike price is usually higher than the underlying stock valuation at the material time of issuance. Why? Well, warrants are issued to attract investors with the anticipation that the market value of the stock will be higher than the strike price in the future. It is an avenue for a company to raise capital over the counter at a higher stock / security valuation compared to what they will typically get on the stock exchange.

However, owning a warrant doesn’t mean one already owns stock and therefore will receive dividends or will have a voting right. It is up to the investor to exercise the right, but not the obligation, bestowed by the warrant in exchange for real stock that can receive dividends from the company. If the warrant is not exercised before expiration date it becomes null and void and the purchase price will not be returned.

A Little More on What is a Warrant

Warrants can be traced back to the early 1920s in the United State. Many large corporations had stock warrants trading, for instance, AT&T, Bank of America, General Motors, Ford Motors and hundreds of others. However, presently Warrants are no longer popular in the United States but are heavily traded in Canada, Hong Kong, Germany and other several countries.

A warrant is a derivative that is traded over the counter and is comparable to an option which is an exchange-traded derivative. In fact, the definition to both a stock warrant and stock option are almost similar. Except, that warrants are actually issued by a company and are for additional shares, whereas options, on the other hand, are created or written between investors to buy or sell outstanding shares.

A warrant or option that gives the right to buy a security at a future date is called a ‘call’ (Call option, call warrant).whereas, a warrant or option that give the right to sell a security at a future date is called a ‘put’ (put warrant, put option).To avoid confusion and to understand options and warrants better, see below examples:

For instance, in the case of an option, a stock could currently be trading at $10 and an investor anticipates that the stock price will rise to $50 in the coming months. One would buy a call option so that when the stock rises to the anticipated price one can buy the stock for $10, then sell it to another investor for $50, and make a profit of $40.

In the case of a warrant, on the other hand, we can look at a deal made by Warren Buffet’s Berkshire Hathaway which acquired warrants for the Bank of America stock at a price of $7.14 each, which cost them roughly $5 billion. Later, the Bank of America stock rose to $24.32 for each share making the exercise of warrants held by Berkshire Hathaway to appreciate from $5 billion to around $17 billion, a gain of $12 billion worth of shares.

Warrants vs. Options

From the foregoing, it is clear that often options and warrants are treated to be in the same line since they all relate to a future transaction. However, there are some key differences and similarities:

Similarities

  •         Both provide an opportunity to an investor to take advantage of anticipated valuable arbitrage future opportunity due to market volatility.
  •         Both give the right to purchase an underlying security at a predetermined price at a future date.
  •         Both are issued with no voting right or expected dividend to the holder unless they are exercised.
  •         The exercise or strike price at the time off issuance is usually higher for both warrants and options compared to the prevailing market valuation.
  •         The exercise or strike price in both warrants and options are determined by duration before expiry and implied market volatility as well as risk free interest rate.
  •         There is no obligation to exercise a warrant or an option and therefore failure to exercise the right renders both useless with no refund guaranteed.
  •         Both bear the risk of loss if not exercised wisely by the holder, for instance, if hold onto it longer and by the time the warrant or option is due for expiry the stock price is still below the strike price.

Differences

  •         Warrants are dilutive, that is, when the holder exercises the rights of the warrant new or additional stock are issued by the company, whereas options are non-dilutive and only outstanding shares are traded.
  •         An option is a right to buy or sell outstanding stock a predetermined price at a future date in exchange for cash, whereas, on the other hand, a warrant is a right to get additional new shares in view of the warrant.
  •         Options are issued by an option exchange such as the Chicago Board Options Exchange. Warrants are issued by the specific company trading its shares over the counter.
  •         Options are standard contracts with stipulated rules governing maturity, duration, size of the contract and exercise price, whereas warrants are non-standardized and therefore flexible.
  •         Terms and condition of a warrant are set by the investor, whereas, the terms and condition in a warrant are set forth by the issuing company.
  •         In a warrant, the transaction is typically between the investor and the issuing company, on the other hand, in the case of options the transaction is between investors.
  •         The maturities of both instruments differ. An option can have a maturity of up to two years whereas a warrant can last as long as fifteen years.
  •         Trading in options involves following principles of a futures market and warrants follow the principle of cash markets.
  •         A warrant can be issued with other instruments such as bonds usually to appeal to investors. However, options are issued independently often used to attract and motivate employees.
  •         The taxation rules applicable also differ. Options are subject to rules governing compensatory items. Warrants, on the other hand, are not compensatory in nature and are therefore taxable in nature.

Warrant Pricing

There are several methods that influence a warrants exercise or strike price. Some of the common pricing method includes the Black-Scholes method and the fractional Brownian method among others. Regardless of the method selected to compute a warrant strike or exercise price both methods considers the intrinsic as well as time value of money.

  1. a)      Intrinsic value

Intrinsic value of a warrant refers to the difference between the current underlying stock price and the determined exercise or strike price at the time of issuance. A warrant can either be In the Money (ITM), Out of the Money (OTM) or At the Money (ATM) in terms of intrinsic value.

  •         A warrant is said to be In the Money (ITM) if the price of the underlying security is higher than the strike price. Such a warrant is said to have intrinsic value since the investor will make meaningful gains if one chooses to exercise the warrant.
  •         On the other hand, a warrant is said to be Out of the Money (OTM) if the strike price of the underlying security is valued above the prevailing security price. In this case the warrant has no intrinsic value but only time value since exercising the warrant will at such a time not make any economic sense.
  •         Lastly, a warrant that is At the Money (ATM) when the strike price and the prevailing market price of the underlying security match.
  1. b)      Time Value

Time value refers to the anticipation that the price of the underlying security will increase in value over time. Alternatively, time value can be defined as the difference between the price of the option/warrant and its intrinsic value. Time value typically decreases as the expiry of a warrant gets closer, that is, it is affected by erosion of time or in other words, time decay.

Time value of a warrant is generally influenced by period length to expiry, volatility, dividends and interest rates:

  •         The more volatile the security is to a bull run will consequently lead to a higher fixed strike price.
  •         Whether the warrant is customized with exemption that permits the holder to receive dividends will influence a higher exercise price. This is the case of detachable and non- detachable warrants that come attached with a bond.
  •         The longer the time to expiry, the greater the time value of the warrant and consequently a higher strike price. This is because the price of the underlying security has a greater probability of moving in-the-money (ITM).
  •         The level of interest rate reflects the opportunity cost associated with capital. Therefore, an increase in interest rates means expensive call warrants and cheaper put warrants.

Types of Warrants

An American warrant can be exercised at any time up to its maturity, while a European warrant can only be exercised at its maturity date. There are several types of warrants available:

1)      Detachable warrants – this are traditional warrants that are issued along with a company’s bond, usually to sweeten the deal. However, the investor has the option of selling the warrant and remaining with the bond.

2)      Non-Detachable (Wedded) Warrants – They are also traditional warrants that come attached with a bond. However, the warrant cannot be separately sold and an investor will have to sell the bond together with the warrant as a package.

3)      Naked Warrants – these are warrants that are issued to investors without an accompanying bond.

4)      Covered warrants – They are non-dilutive in nature as the shares to be granted already exist, that is they are covered. They are specifically issued by financial institutions and not any other company. They are also sometimes referred to as naked warrants too since they come with no accompanying bond.

5)      Equity warrants (Call and Put Warrants) – A call warrant allows the holder to buy equity or shares from the issuer, whereas, A put warrant allows the holder to sell shares back to the issuer. The primary difference between the two is that a call warrant will buy a specified number of shares from the issuer at a future date for a set price. A put warrant, on the other hand is a representation of the equity value that an investor can sell back to the issuing company in the future for a set price.

6)      Penny warrant – When the nominal exercise price of a warrant is set for as low as $0.01 per share, such a warrant is referred to as a penny warrant.

7)      Basket warrants – This kind of options is generally used by multinational corporations which characteristically have multi-currency cash flows. This means that the company has the option of buying different currencies in their “basket” at a future date at an already predetermined price regardless of the prevailing exchange rate.

8)      Cash or share warrants –This are trade warrants whose compensation can either be in cash or exchanged for shares.

Trading warrants

Getting information on warrants that are being traded can be difficult and time consuming as warrants are usually traded over the counter and rarely on the stock exchange. Nevertheless, if a warrant is traded it will have the extension ‘W’ added to the stock name.

Generally, Warrants that are trading on an exchange will sell for a premium price greater than the minimum value due to anticipation by investors that the price of the underlying security will rise in the future and the demand will drive the price up. However, the price of the traded warrant will deep as the expiry date nears.

References for Warrants

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