Warrant Exercise

Warrant exercise is the act of using a warrant to acquire the underlying security, normally new ordinary shares of the issuing company, at the price fixed in the warrant's terms. The holder gives notice, pays the exercise price and receives shares in return; the warrant is then cancelled. The term also covers the operational process by which brokers, custodians and the company's agent carry this out.

A warrant resembles a call option, but it is issued by the company itself, usually has a life of several years, and on exercise causes the company to issue new shares and receive cash. Companies issue warrants as a sweetener attached to bonds or share placements, as part of restructurings and in the units sold by a SPAC. Because holders must choose whether and when to act, exercise is treated by custodians as a voluntary corporate action.

The warrant instrument or agreement sets out the conditions:

• Exercise price. The amount payable for each share, also called the strike or subscription price.
• Exercise ratio. The number of shares obtained for each warrant, which need not be one for one.
• Exercise period. American-style warrants may be exercised at any time up to the expiration date, European-style warrants only on that date, and others on a series of fixed dates.
• Settlement method. Physical settlement delivers shares against payment; some warrants settle in cash or allow cashless exercise.
• Adjustment provisions. The price and ratio are adjusted for events such as a stock split, bonus issue or rights issue, so that the warrant's value is not eroded.
• Issuer rights. Some warrants may be redeemed by the company for a nominal sum once the share price has stayed above a set level, which in practice forces holders to exercise.

A holder who decides to exercise instructs its broker or custodian, which blocks the warrants in the account and passes an exercise notice, with the payment, through the depository to the warrant agent. The agent checks the notice, collects the funds and arranges for the company to issue the shares, and the transfer agent or registrar records them in the name of the holder or its nominee. The new shares are credited through the settlement system, typically some days after the exercise date, and are admitted to trading alongside the existing ones.

As expiry approaches, custodians send clients a notice of the final date and their own earlier deadline for instructions. Between institutions the messages follow the standard corporate action formats, with a dedicated event type for warrant exercise. Fractions of a share that arise from the ratio are usually rounded down or settled through a cash-in-lieu payment.

Exercise is worthwhile only when the share price is above the exercise price. A warrant with an exercise price of 11.50 on a share trading at 15.00 has an intrinsic value of 3.50; the holder who exercises pays 11.50 for a share that could be sold for 15.00. If the share trades at 9.00, exercising would mean paying more than the market price, and the warrant would be left unexercised.

Before expiry a listed warrant normally trades above its intrinsic value, because it still carries the chance of further gains. A holder who wants to realise value is then usually better off selling the warrant than exercising early. At expiry the remaining time value is gone, and a warrant that is in the money should be exercised or sold, since one that is neither simply lapses. Some markets and agents exercise in-the-money warrants automatically at expiry; where they do not, forgotten warrants are a recurring source of investor losses and of claims against intermediaries.

Under a cashless or net exercise, the holder pays nothing and receives fewer shares, equal in value to the warrant's intrinsic value. In the example above, a holder of 1,000 warrants exercising in cash would pay 11,500 and receive 1,000 shares worth 15,000. On a cashless basis the holder would receive shares worth the 3,500 gain, about 233 shares, with the fraction settled in cash. The company receives no money but issues fewer shares. Exact formulas vary between warrant agreements.

Exercise increases the number of shares in issue and brings cash into the company equal to the exercise price for each share. Because the new shares are issued below the market price, existing shareholders' ownership is diluted; analysts allow for this by including in-the-money warrants in diluted earnings per share. In the accounts, the proceeds are added to share capital and the share premium account. Whether outstanding warrants are classified as equity or as a liability depends on their terms under IAS 32 and the equivalent US rules.

The word is also used for covered warrants and similar structured products issued by banks over shares, indices, currencies or commodities. These are closer to exchange-traded options: the bank, not the underlying company, is the counterparty, no new shares are created, and most are settled in cash and exercised automatically at expiry if they have value. Company warrants are also distinct from subscription rights, which are short-lived and offered to existing shareholders in proportion to their holdings, although the process of a rights exercise is operationally similar.