Value of a Warrant:
The market price of a warrant fluctuates between minimum and maximum limits. When the current market price of the stock Ps is greater than the exercise price Pe, the minimum value (Mv) is given by,
Mv = (Ps - Pe) x N, where, N is the number of shares.
When the current market price is lower than the exercise price, then the minimum value is zero, as there is no gain from exercising it.
If the warrant price was lower than this value, any investor by arbitrage would make risk-free profits. This is explained below.
Assume the market price of the share to be Rs.40, the warrant price Rs.4 and the exercise price Rs.33. Under these conditions, the total investment by the trader would be Rs.37 (to buy the warrants, exercise them and sell away the shares) and when he sells the underlying share he will realize Rs.40 ignoring the transaction costs. On the whole, he makes a profit of Rs.3. Therefore, the market price of the warrant should at least be equal to the minimum value.
The maximum value of the warrant is given by Ps x N. The warrant holders can realize this maximum value as they do not receive any dividend on the underlying stock during the period they hold the warrant.
The difference between the warrant price and the minimum value of the warrant is called the warrant premium. Usually, the magnitude of the premium over the intrinsic value for a given change in the stock and the exercise price depends on factors like the expiration period, variability in the stock price and the leverage provided by the warrant.
Let us consider the leverage effect it provides. Assume the stock's current market price to be Rs.33 and the warrant price Rs.7. After one month assume that the price of the stock increased to Rs.35 with a simultaneous increase in the warrant to Rs.9. The percentage change in price of the share is given by (35 - 33)/33 = 5.71%. And the percentage change in the warrant price is given by (9 - 7)/7 = 28.57%. Therefore, a warrant holder will experience a rise of 28.57% for a similar absolute change in the price of the share. The leverage effect acts in a reverse direction when the price of the underlying stock decreases.