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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 Deutsche Börse and Hong Kong. In 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.
Warrants have similar characteristics to that of other equity derivatives, such as options, for instance:
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:
Warrants are longer-dated options and are generally traded over-the-counter.
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.
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:
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There are various methods (models) of evaluation available to value warrants theoretically, including the Black-Scholes evaluation model. However, it is important to have some understanding of the various influences on warrant prices. The market value of a warrant can be divided into two components:
There are certain risks involved in trading warrants—including time decay. Time decay: "Time value" diminishes as time goes by—the rate of decay increases the closer to the date of expiration.
A wide range of warrants and warrant types are available. The reasons you might invest in one type of warrant may be different from the reasons you might invest in another type of warrant.
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.
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. These are also called covered warrants 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 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.
The term warrant is sometimes used in the US to mean a warrant of payment which is a check or an IOU issued by a governmental agency. California differentiates between regular warrants, which can be exchanged immediately for cash and registered warrants which are IOUs.
In the late 1990s, when the State of California had a budget crisis due to a disagreement between the governor and the legislature, the state treasurer was forced to issue warrants paying 18% interest in lieu of being able to pay the state's bills with real money. The state had not issued warrants since before the Depression of the 1930s. Many institutions accepted them at face value because of the interest provision. Interestingly, the controller of Los Angeles County was buying the warrants because the county had surplus funds to take advantage of the higher interest rates on the warrants.
In some states, a warrant is a demand draft drawn on a government's treasury to pay its bills. Checks or electronic payments have replaced these warrants, but in Arkansas, some counties and school districts uses warrants for non-electronic payments.
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