http://www.investopedia.com/terms/w/warrant.asp

http://www.incademy.com/courses/Traditional-corporate-equity-warrants/Warrant-exercise/17/1068/10002

http://canadianwarrants.com/faq.htm

17. Warrant exercise

A source of confusion and worry for investors is often the process of exercising the subscription rights of warrants. When can I exercise? Do I have to? How much do I have to pay? What if I don't have enough capital to pay the full amount? Where do I send the money? These are all questions commonly asked by warrant-holders.

But don't worry. While the subscription rights underpin the theoretical value of warrants, in practice individual investors rarely exercise the rights. This is explained in greater detail below.

What does warrant exercise mean?

Exercising a warrant means paying the subscription (exercise) price to convert your warrants into shares. If the subscription price of a warrant is 50p, effectively you pay 50p to the company and they issue a new share to you. Therefore, upon exercise,

1. The investor realises the intrinsic value of the warrant, and the warrant ceases to exist.
2. The money paid to exercise the warrant provides the company with additional capital.

When warrants may be exercised

Most UK warrants have what is known as European-style exercise terms, which usually specify an annual date, or short period, for exercise. For example,

Each Honeysuckle Group Warrant entitles the holder to subscribe for 1 Ordinary share @4p during 30 day period following dispatch of Interim Statement or Report & Account until 2004

Some warrants have American-style exercise terms, where the warrants are continuously exercisable throughout the life of the warrant. For example,

Keystone Software Warrants have the right to subscribe for one Ordinary Share of 5p @50p at any time until 30th November 2006.

There is little standardisation on warrant terms, therefore it is always important to carefully check the exact wording of the subscription rights. For example, Luminar warrants have an unusual clause concerning earnings growth,

Within 28 days after publication of Annual Report for each year ending 28th February 2002 through' 2009. Performance condition dictates that pre-tax earnings must rise at an average compound rate of 20%pa over three years commencing 1st March 1999 or the warrants are void.

For company registrars and finance directors, discrete periods for exercise are simpler to deal with than continuous exercise. A possible drawback of discrete exercise periods is that warrants may trade at a discount shortly before expiry (with arbitrageurs unable to buy the warrants and exercise them immediately). However, in practice, the difference between European-style and American-style warrants is not great, and investors should not be unduly concerned by the difference.

When warrants should be exercised

The preceding section dealt with when warrants may be exercised. But just because a warrant can be exercised, doesn't necessarily mean it is wise to do so. Warrants confer the right to exercise, not the obligation.

Before exercising warrants there are some questions that should be asked:

1. Does the warrant have intrinsic value?

Recall that a warrant has intrinsic value if the share price is above the warrant exercise price. It is only sensible to exercise warrants if they have intrinsic value - in other words; the share price is above the exercise price. This is illustrated in the two examples below.

2. Does the warrant trade at a premium?

When a warrant is exercised, the intrinsic value is realised (see above), but any premium on the warrant is lost.

The premium on a warrant represents its time value - the potential for the share price to increase over the remaining life of the warrant. But exercise of a warrant before expiry forfeits that time value.

Instead of exercising warrants on a premium, these warrants should be simply sold directly in the warrant market. By selling a warrant, both its intrinsic value and time value are captured in the warrant price.

If you are lucky to ever find a warrant trading on a large discount, then exercise may be considered. For example, in Example A above, the shares can be bought at 114 (by buying the warrants at 14 and exercising them at 100), and then the shares can be sold straight back into the market at 120, realising a gain of 6. In theory this sounds good. In practice, warrants rarely trade at large discount, and when they do, they may not be immediately exercisable or any potential profit is liable to disappear with the costs of trading.

Given that the vast majority of warrants do trade at a premium most of the time, the conclusion is that it is rarely sensible to exercise warrants. Better to just sell them in the warrant market.

3. Do you really want to own the shares?

If the warrants are trading at a discount, or even a small premium, then the costs of exercising the warrants into the shares may be cheaper than selling the shares and then buying the warrants.

If you do decide to exercise, check that you have sufficient capital to pay the exercise price on the warrants.

Final expiry

The decision process changes a little at expiry.

Warrants which have not been exercised become worthless at expiry. (You might like to read that sentence again, to appreciate its full import!)

At expiry, warrants have no time value left, so there will be no premium. But they will commonly have some intrinsic value. If the warrants are not exercised, any intrinsic value will be lost.

The primary decision here is whether the warrant holder wants to hold the shares or not. In most cases they don't, and so, not wanting to bother with the exercise process, they will simply sell the warrants into the market. Long-term shareholders (who received their warrants as part of a scrip issue) may decide to exercise all their warrants; or sell part of their warrant holding into the market and use the proceeds to exercise the remaining warrants.

If the warrants have no intrinsic value at expiry, then the warrant holder has no option but to let the warrants lapse.

Summary

While the subscription rights underpin the theoretical value of warrants, in practice individual investors rarely exercise the rights. Many active warrant investors will never exercise warrants: they buy warrants and then simply sell them back into the market when they want to close their position.