In finance, a warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed price called exercise price until the expiry date.
Warrants and options are similar in that
the two contractual financial instruments allow the holder special rights to
buy securities. Both are discretionary and have expiration dates. The word
warrant simply means to "endow with the right", which is only
slightly different from the meaning of option.
Warrants are frequently attached to bonds
or preferred stock as a sweetener, allowing the issuer to pay lower interest
rates or dividends. They can be used to enhance the yield of the bond and make
them more attractive to potential buyers. Warrants can also be used in private
equity deals. Frequently, these warrants are detachable and can be sold
independently of the bond or stock.
In the case of warrants issued with
preferred stocks, stockholders may need to detach and sell the warrant before
they can receive dividend payments. Thus, it is sometimes beneficial to detach
and sell a warrant as soon as possible so the investor can earn dividends.
Warrants are actively traded in some
financial markets such as German Stock Exchange (Deutsche Börse) and Hong Kong. In the Hong Kong Stock Exchange, warrants
accounted for 11.7% of the turnover in the first quarter of 2009, just second
to the callable bull/bear contract.
Structure and Features
Warrants have similar characteristics to
that of other equity derivatives, such as options, for instance:
- Exercising:
A warrant is exercised when the holder informs the issuer their intention
to purchase the shares underlying the warrant.
The warrant parameters, such as exercise
price, are fixed shortly after the issue of the bond. With warrants, it is
important to consider the following main characteristics:
- Premium:
A warrant's "premium" represents how much extra you have to pay
for your shares when buying them through the warrant as compared to buying
them in the regular way.
- Gearing
(leverage): A warrant's "gearing" is the way to ascertain how
much more exposure you have to the underlying shares using the warrant as
compared to the exposure you would have if you buy shares through the
market.
- Expiration
Date: This is the date the warrant expires. If you plan on exercising the
warrant, you must do so before the expiration date. The more time
remaining until expiry, the more time for the underlying security to
appreciate, which, in turn, will increase the price of the warrant (unless
it depreciates). Therefore, the expiry date is the date on which the right
to exercise ceases to exist.
- Restrictions
on exercise: Like options, there are different exercise types associated
with warrants such as American style (holder can exercise any time before
expiration) or European style (holder can only exercise on expiration
date).
Warrants are longer-dated options and
are generally traded over-the-counter.
Secondary Market
Sometimes the issuer will try to
establish a market for the warrant and to register it with a listed exchange.
In this case, the price can be obtained from a stockbroker. But often, warrants
are privately held or not registered, which makes their prices less obvious. On
the NYSE, warrants can be easily tracked by adding a "w" after the
company's ticker symbol to check the warrant's price. Unregistered warrant
transactions can still be facilitated between accredited parties and in fact,
several secondary markets have been formed to provide liquidity for these
investments.
Comparison with Call Options
Warrants are very similar to call
options. For instance, many warrants confer the same rights as equity options
and warrants often can be traded in secondary markets like options. However,
there also are several key differences between warrants and equity options:
- Warrants
are issued by private parties, typically the corporation on which a
warrant is based, rather than a public options exchange.
- Warrants
issued by the company itself are dilutive. When the warrant issued by the
company is exercised, the company issues new shares of stock, so the
number of outstanding shares increases. When a call option is exercised,
the owner of the call option receives an existing share from an assigned
call writer (except in the case of employee stock options, where new
shares are created and issued by the company upon exercise). Unlike common
stock shares outstanding, warrants do not have voting rights.
- Unlisted
Warrants are considered over the counter instruments and thus are usually
only traded by financial institutions with the capacity to settle and
clear these types of transactions.
- A
warrant's lifetime is measured in years (as long as 15 years), while
options are typically measured in months. Even LEAPS (long-term equity
anticipation securities), the longest stock options available, tend to
expire in two or three years. Upon expiration, the warrants are worthless
unless the price of the common stock is greater than the exercise price.
- Warrants
are not standardized like exchange-listed options. While investors can
write stock options on the ASX (or CBOE), they are not permitted to do so
with ASX-listed warrants, since only companies can issue warrants and,
while each option contract is over 1000 underlying ordinary shares (100 on
CBOE), the number of warrants that must be exercised by the holder to buy
the underlying asset depends on the conversion ratio set out in the offer
documentation for the warrant issue.
- As
with options, warrants slowly lose extrinsic value due to time decay. The
sensitivity to this is called theta.
Types of Warrants
The reasons you might invest in one type
of warrant may be different from the reasons you might invest in another type
of warrant. A wide range of warrants and warrant types are available:
- Equity
warrants: Equity warrants can be call and put warrants. Callable warrants
offer investors the right to buy shares of a company from that company at
a specific price at a future date prior to expiration. Puttable warrants
offer investors the right to sell shares of a company back to that company
at a specific price at a future date prior to expiration.
- Covered
warrants: A covered warrants is a warrant that has some underlying
backing, for example the issuer will purchase the stock beforehand or will
use other instruments to cover the option.
- Basket
warrants: As with a regular equity index, warrants can be classified at,
for example, an industry level. Thus, it mirrors the performance of the
industry.
- Index
warrants: Index warrants use an index as the underlying asset. Your risk
is dispersed—using index call and index put warrants—just like with
regular equity indexes. They are priced using index points. That is, you
deal with cash, not directly with shares.
- Wedding
warrants: are attached to the host debentures and can be exercised only if
the host debentures are surrendered
- Detachable
warrants: the warrant portion of the security can be detached from the
debenture and traded separately.
- Naked
warrants: are issued without an accompanying bond and, like traditional
warrants, are traded on the stock exchange.
- Cash
or Share Warrants in which the settlement may be in the form of either
cash or physical delivery of the shares - depending on its status at
expiry.
Traditional
Traditional warrants are issued in
conjunction with a bond (known as a warrant-linked bond) and represent the
right to acquire shares in the entity issuing the bond. In other words, the
writer of a traditional warrant is also the issuer of the underlying
instrument. Warrants are issued in this way as a "sweetener" to make
the bond issue more attractive and to reduce the interest rate that must be
offered in order to sell the bond issue.
Example
- Price
paid for bond with warrants
- Coupon
payments C
- Maturity
T
- Required
rate of return r
- Face
value of bond F
Covered or naked
Covered warrants, also known
as naked warrants, are issued without an accompanying bond and, like
traditional warrants, are traded on the stock exchange. They are typically
issued by banks and securities firms and are settled for cash, e.g. do not
involve the company who issues the shares that underlie the warrant. In most
markets around the world, covered warrants are more popular than the
traditional warrants described above. Financially they are also similar to call
options, but are typically bought by retail investors, rather than investment
funds or banks, who prefer the more keenly priced options which tend to trade
on a different market. Covered warrants normally trade alongside equities,
which makes them easier for retail investors to buy and sell them.
Third-party
warrants
A third-party warrant is a
derivative issued by the holders of the underlying instrument. Suppose a
company issues warrants which give the holder the right to convert each warrant
into one share at $500. This warrant is company-issued. Suppose, a mutual fund
that holds shares of the company sells warrants against those shares, also
exercisable at $500 per share. These are called third-party warrants. The
primary advantage is that the instrument helps in the price discovery process.
In the above case, the mutual fund selling a one-year warrant exercisable at
$500 sends a signal to other investors that the stock may trade at $500-levels
in one year. If volumes in such warrants are high, the price discovery process
will be that much better; for it would mean that many investors believe that
the stock will trade at that level in one year. Third-party warrants are
essentially long-term call options. The seller of the warrants does a covered
call-write. That is, the seller will hold the stock and sell warrants against
them. If the stock does not cross $500, the buyer will not exercise the
warrant. The seller will, therefore, keep the warrant premium.
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