The following Q&As using fictitious names for a warrant and its underlying stock and figures explain how "dividends expected to be paid by the underlying stock" affect a warrant's price.
I bought call warrant A linked to the underlying stock B with an expiry date of late April. Why did call warrant A trade below its intrinsic value with a negative premium of 1% in mid-March?
This seemed unreasonable as the warrant price should at least equal its intrinsic value, i.e. the excess of the prevailing market price of the underlying stock B over the exercise price of call warrant A.
While there is nothing wrong with the aforesaid definition of intrinsic value and in most cases derivative warrants do trade above this "intrinsic value", this does not mean that this intrinsic value must be the minimum value of a derivative warrant. As explained below, it is possible for a derivative warrant to trade below this "intrinsic value".
Holding a call warrant differs from holding the underlying stock, especially since the holders of the call warrant are not entitled to receive any dividends that might be declared by the underlying stock. In this particular case, it was noticed that the underlying stock B was due to announce its annual results in late March. Based on previous practices, stock B would likely go ex-dividend in mid-April. With an expiry date for call warrant A of late April, the market price of stock B used would be the ex-dividend price in determining the payout of call warrant A on this expiry date. This would result in a lower payout to call warrant holders than it otherwise should. Although the final dividend that stock B would declare was still unknown in mid-March, it was widely anticipated that the dividend would be no less than $1.5. It was not unreasonable for potential investors and the liquidity provider to deduct the dividend element when pricing call warrant A.
If so, how would the price of call warrant A change on the dividend announcement date and on the ex-dividend date of stock B?
Assuming other factors remain constant, if the amount of the declared dividend was in line with what the market expected, there would be no change in the market price of call warrant A on either the dividend announcement date or the ex-dividend date of stock B, because the dividend element had already been priced into call warrant A.
What if stock B eventually declared a dividend lower than expected? How about if the declared dividend is larger than expected?
If the liquidity provider used $1.5 as the dividend discount factor to price call warrant A and stock B eventually declared a dividend lower than expected, investors who bought call warrant A at a cheaper price would gain as the price of warrant A would be expected to move up, assuming other factors remain constant. The liquidity provider who sold the warrant at the discounted price might lose.
On the other hand, if stock B declared a larger dividend than expected, the price of warrant A would be expected to drop further, assuming other factors remain unchanged. Accordingly, investors who bought warrant A would lose.
Why don't all derivative warrants reflect the negative impact of the dividend discount, and thus trade with a negative premium? When would this factor become apparent?
Generally speaking, at the time of launch, a derivative warrant is normally issued at a significant premium to reflect the time value of the warrant. The small negative impact of the dividend discount is embedded in the premium and may not be easily noticeable. In this particular case, since call warrant A was about to expire in late April, its remaining time value had diminished to such an extent that the negative effect of the expected dividend payment became visible, as reflected by the negative premium.
Why was the negative impact of the dividend discount not visible for comparable options on stock B trading on the Stock Exchange of Hong Kong (SEHK)?
While stock options are similar to derivative warrants in many aspects, there are some key differences that might lead to significant price differences. In particular, stock options listed on the SEHK are American style, which means that they can be exercised on or before the expiry date. Derivative warrants listed on the SEHK (e.g. call warrant A) are European style, which means they can be exercised only on the expiry date. Because of this feature, a call stock option holder can exercise the option before expiry to receive the underlying stock before the ex-dividend date. Thus, in practice, a stock option should not be affected by dividend payments and should therefore trade above its intrinsic value all the time.
So, does it mean that stock options are better than derivative warrants?
Both European style and American style options (including warrants which are a kind of option) exist in the market and they serve different purposes. It is hard to say which style is necessarily better than the other. More importantly, investors should understand what they are buying and should not confuse the two different kinds of product, as each has its own characteristics. As a side issue, assuming all other things equal, it is generally true that a European style option is cheaper than an American style option.