Warrants: Gearing, Premium and Time Value
What the exam tests
This domain tests listed warrants: what the issuer is selling, how intrinsic value separates from time value, how gearing and effective gearing differ, and what expiry and exercise actually mean for the holder.
Core rules
- A call warrant gives the right to buy the underlying at the strike; a put warrant gives the right to sell. Listed warrants are typically issued by a bank, are covered by the issuer's hedge, and are cash-settled at expiry.
- Intrinsic value for a call is the underlying price minus the strike, floored at zero. Anything above intrinsic value is time value, which decays as expiry approaches.
- Gearing measures leverage: gearing = underlying price / (warrant price x exercise ratio). Effective gearing multiplies that by delta, giving the approximate percentage move in the warrant for a 1% move in the underlying.
- Premium is what you pay over the intrinsic position, expressed as a percentage of the underlying price. Higher premium means more time value at risk.
- Warrants are not shares: the holder has no voting rights and no dividend entitlement, and the issuer's creditworthiness matters.
Worked example: 1:1 call warrant
Underlying share R50.00, strike R45.00, warrant price R7.50, exercise ratio 1, delta 0.70.
- Intrinsic value = 50.00 - 45.00 = R5.00
- Time value = 7.50 - 5.00 = R2.50
- Gearing = 50.00 / (7.50 x 1) = 6.67 times
- Effective gearing = 0.70 x 6.67 = 4.67 times
- Premium = (45.00 + 7.50 - 50.00) / 50.00 = 5.0%
If the share rises 1% to R50.50, the warrant should gain roughly 4.67%, about 35c. If the share stays flat, that R2.50 of time value bleeds away through expiry.
Traps that cost marks
- Quoting gearing as the return you will earn; effective gearing and delta drive actual sensitivity.
- Forgetting the exercise ratio in the gearing formula.
- Treating a warrant as an ordinary share with voting and dividend rights.