What happens when a warrant is out-of-the-money, or in-the-money? Can you give me an example of both please.
Warrants are financial instruments that derive their value from another underlying instrument and are issued by banks, governments and other institutions. They are commonly and broadly split into two categories; investment style warrants, which are longer term and carry a reduced degree of risk, and trading style warrants, which are typically shorter term and are associated with higher levels of risk and return.
Similar to options there are two main types of warrants; Call warrants and put warrants. Call warrants give the holder the right to buy the underlying asset at maturity, while put warrants give the holder the right to sell the underlying asset at maturity. As with options, each warrant can also be regarded as being “in”, “at” or “out” of the money, which is a reflection of their intrinsic value.
The intrinsic value is the difference between the exercise price and the current price of the underlying share, and is a key component in determining the market value of a warrant. A warrant’s intrinsic value is always greater than or equal to zero.
A call warrant is in-the-money when the exercise price is lower than the price of the underlying share. For example, an investor holds a BHP call warrant with an exercise price of $35.00, meaning, at maturity the investor can purchase BHP shares for $35.00. If BHP shares were currently trading at $38.00, the investor holds an “in-the-money” warrant, with an intrinsic value of $3.00 per warrant.
Conversely, a call warrant is out-of-the-money when the exercise price is higher than the price of the underlying share. Using the same example, if BHP shares were trading at $30.00 the investor’s BHP call warrant with an exercise price of $35.00 would be termed “out-of-the-money” and would have an intrinsic value of $0.
The same logic can be applied to put warrants. A put warrant is in-the-money when the underlying share price is below the exercise price. As an example, an investor holds a WOW warrant with an exercise price of $30.00, which gives them the right to sell WOW shares for $30.00 at maturity. If WOW shares are currently trading at $27.00, the investor’s warrant is “in-the-money”, and has an intrinsic value of $3.00 per warrant.
On the other hand, a put warrant is out-of-the-money when the underlying share price is above the exercise price. Using the same example, if WOW shares were trading at $32.00 the investor’s WOW put warrant with an exercise price of $30.00 would be termed “out of the money” and would have intrinsic value of $0.
Finally, both call and put warrants are termed “at the money” when the exercise price is equal to the price of the underlying. Like “out of the money” warrants, at-the-money warrants have an intrinsic value of $0.
For more information
For further information on Warrants, visit the Australian Stock Exchange website www.asx.com.au. The ASX have a booklet titled “Understanding Trading and Investment Warrants” which is designed to give you a comprehensive understanding of the different types of warrants and how they work. A number of strategies are also available for download.
By Matt Comyn, General Manager, CommSec
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