Call options and warrants are both forms of investment contracts. Within a specific time frame and at a predetermined price, the holder of a warrant has the right but not the duty to purchase shares of common stock from the issuing corporation.
Like put options, call options give the holder the right but not the responsibility to purchase a certain number of shares of common stock at a specified price within a specified time frame.
Comparing Warrants and Call Options
Both warrants and calls have the same essential characteristics: The guaranteed price at which the purchaser of a warrant or option can acquire the underlying asset from the seller is known as the strike price or exercise price. The word "exercise price" is recommended in the context of warrants.
Imagine a warrant for a stock trading at $4, with an exercise price of $5. The warrant is presently valued at 50 cents and expires in a year. The warrant's value will increase if the underlying stock price rises over $5 before the expiration date.
Let's pretend the underlying stock trades at $7 right before the warrant's expiration in a year. The warrant's value would increase to $2 at that point. The warrant's value will plummet if the underlying stock trades at $5 or less just before the warrant's expiration.
A Comparison of Warrants and Calls
Unlike call options, warrants have three key advantages:
Issuer:
Unlike exchange-traded options, which are provided by markets like the Chicago Board Options Exchange in the United States1 and the Montreal Exchange in Canada, warrants are issued by individual companies. Therefore, exchange-traded options have more uniform characteristics, such as expiration dates and the number of shares covered by a given option contract, than warrants do.
Maturity:
Commonly, warrants have longer expiration dates than options. Warrants usually have a maturity of one to two years, although in exceptional cases, they might have a maturity of more than five years. On the other hand, call options typically expire within a month, but their maturities might extend to a year or more. Options with a longer time frame are typically less liquid.
Dilution:
When a warrant is exercised, the corporation must issue more stock shares, diluting existing shareholders. Since a call option is a derivative instrument on an already issued share of common stock, the exercise of a call option does not create more shares.
Why Do Firms Give Out Warrants and Calls?
Warrants serve as a "sweetener" for an equity or debt transaction. Warrants are popular with investors because they give them a more significant stake in the firm. Warrants are included in equity and debt offerings because of their potential to reduce financing costs and guarantee extra funds if the stock performs well.
If a warrant is attached to a bond financing, investors are more likely to choose a somewhat lower interest rate than they would with a standard bond financing.
Intrinsic &'' Time Value
Warrant pricing is affected by the same factors as call option pricing, adding a few peculiarities. First, it's essential to grasp the intrinsic and temporal values that make warrants and calls valuable.
Intrinsic value
A call or warrant is the spread between the stock's current price and the strike price at which the warrant or call can be exercised. The inherent value is never less than zero and never more than one. If a stock is now trading at $10 and the strike price of a call on the stock is $8, the intrinsic value of the call is $2. The value of this call option is zero if the stock price is $7.
Time value
For a stock selling at $10, the intrinsic value would be $2, and the time value would be 50 cents if the price of an $8 call option were $2.50. When an option has no underlying asset value, its value is entirely determined by its time value. Time value is the probability that the underlying stock price will be higher than the option's strike price at expiration.
Warrant and Call Option Pricing
Analysts can employ a variety of sophisticated mathematical models, but in the end, supply and demand matter most when calculating the value of a call option. However, within each model, specialists in call option pricing allocate value based on the delta between the underlying stock price and the call option's strike price, the period until the call option expires, and the estimated volatility in the price of the underlying securities.
Summary
Despite the many advantages that warrants and calls present to investors, it is essential to note that, as derivative products, they are not without their share of dangers. Therefore, before incorporating these flexible products into portfolios, investors should have a solid grasp of how they work.
