What is a Warrant Premium?
A warrant premium is the percentage difference between the market price of a security and the price an investor pays for that security when buying and exercising a warrant.
The formula for the warrant premium is:
Warrant Premium = 100 x [(Warrant Price + Exercise Price – Current Share Price) / Current Share Price]
How Does a Warrant Premium Work?
Warrants are securities that give the holder the right (but not the obligation) to buy a certain number of securities (usually the issuer's common stock) at a certain price before a certain time. Warrants are not the same as call options or stock purchase rights.
For example, if Company XYZ issued $100 million of bonds with warrants attached, each bondholder might get a $1,000 face-value bond and the right to purchase 100 shares of Company XYZ stock at, say, $20 per share over the next five years. The price at which a warrant holder can purchase the underlying securities is called the exercise price or strike price. In our example, the exercise price is $20, which is, say, 15% higher than what Company XYZ stock was trading at when the bonds were issued. The warrant's exercise price often rises according to a schedule as the bond matures.
Let's say the stock is currently trading at $10 per share right now. Using this information and the formula above, we can calculate the warrant premium:
Warrant Premium = 100 x [($0 + $20 - $10) / $10] = 100%
Why Does a Warrant Premium Matter?
Warrants tend to trade above their minimum value. For example, consider a warrant to purchase 100 shares of Company XYZ for $20 per share anytime in the next five years. If Company XYZ shares rose to $100 during that time, the warrant holder could purchase the shares for $20 each and immediately sell them for $100 on the open market, pocketing a profit of ($100 - $20) x 100 shares = $8,000. Thus, the minimum value of each warrant is $80.
It is important to note, however, that if the warrants still had long to go before their expiration date, investors might speculate that the price of Company XYZ stock could go even higher than $100 a share. This speculation, accompanied by the extra time for the stock to rise further, is why a warrant with a minimum value of $80 could easily trade above $80. But as the warrant gets closer to expiring (and the chances of the stock price rising in time to further increase profits get smaller), that premium would shrink until it equaled the minimum value of the warrant (which could be zero if the stock price falls to below $20 rather than rising above $100).
This opportunity to participate in the upside of another security gives investors a little diversification and thus is a way to mitigate risk. As a result, companies often issue bonds and preferred stock with warrants attached as a way to enhance the demand and marketability of the offering. This in turn lowers the cost of capital for the issuer.