Question

Mr. John Halley has $800 to invest in the market He is considering the purchase of 80 shares of Comet Airlines at $10 per share. His broker suggests that he may wish to consider purchasing warrants instead. The warrants are selling for $2, and each warrant allows him to purchase one share of Comet Airlines common stock at $20 per share. a. How many warrants can Mr. Halley purchase for the same $800? (Do not round intermediate calculations and round your answ to the nearest whole number.) nswer Number of warrants purchased warrants b. If the price of the stock goes to $30, what would be his total dollar and percentage return on the stock? (Do not round intermediate calculations. Round the first answer to the nearest whole dollar. Input the second answer as a percent rounded to 2 decimal places.) Total dollar return on the stock Percentage return on the stock

Answer 1

Solution:-

A warrant is a financial instrument issued by a company that gives right to the warrant holder to acquire specified number of shares against each warrant on a specified date and at a specified price. This limits the investor's downside to the warrant price (as that's the maximum amount which can be lost by the investor) and gives opportunity bet on the potential upside.

For e.g., as given in the question, if Mr. Hailey invests directly in the stock which is trading for $10 per share, he risks losing the entire $10 for every share. On the contrary, if he buys warrants for $2 each, his downside gets limited to $2 if the share price goes down. The flip side to that is that warrants only generate profits if the stock price goes over the exercise price ($20) while the direct investment in stock would yield profits if the stock goes above $10.

(a) The market price of each warrant is $2 and Mr. Hailey has $800 to invest

No. of warrants that can be purchased= $800/$2 = 400 warrants

(b) The current stock price is $10, Mr. Hailey could buy 80 shares with his $800 investment. So, if the price goes up to $30 per share

Dollar return on the stock= ($30-$10)*80 = $1,600

% return on the stock = (30-10)/10 = 200%

(c) The price of warrant can be calculated as follows:

Price of the warrant = (Stock price-exercise price) + Speculative premium

If stock goes up to $30 per share and speculative premium is zero, than the price of the warrant would be

Price of the warrant = ($30-$20)+0 = $10 per warrant
Total dollar return on the warrant = ($10-$2)*400 warrants = $3,200

% return on warrants = ($10-$2)/$2 = 400%

(d) If speculative premium remains $3.50, the stock price level at which warrant becomes zero is as follows:

Price of the warrant = (Stock price-exercise price) + Speculative premium

0 = (Stock price-$20)+3.5

Stock price = $16.5

Therefore, the stock would have to come down to $16.50 in order for the warrant to lose all its value