What are warrants?
Warrants are derivatives that provide the holder with the right to sell or buy a security at a price before expiry. Warrants provide a right and not an obligation to buy or sell a security. A warrant is generally purchased for securities such as equity. It contains information such as issuing company name, number of securities, date of issue, price, and investor information. The price at which the security is sold or purchased is called the strike price or exercise price. A warrant that provides the right to buy the security is known as a call warrant. Alternatively, the warrants that provide the right to sell the security are known as put warrants. While the concept of a warrant is similar around the globe, the way they are used may differ among countries. For example, American warrants are allowed to be used anytime before expiry whereas European warrants are used only at the time of expiry.
Warrants vs Options
Firstly, the company using its own stock as the underlying security issues an equity warrant. The equity warrant provides the holder with the right to sell or buy the common stock at a specific price and date. When the warrant is used, the shares fulfilling the obligation are received from the company and not from another investor.
On the other hand, an equity option is a contract between two investors that give the holder the right to sell or buy a stock at a specific price before the contract expiration date.
Stock options are generally bought by investors if they think that the stock price would go up or down. This depends on the type of option. Therefore, the purpose of stock options is for the investor to make excess funds when possible. However, when a stock warrant is bought, it provides capital for the company. In other words, by purchasing stock through a warrant, the holder contributes to the company’s capital.
Purpose of a warrant
A company may choose to issue warrants on its stocks and bonds to attract more investors. For example, if the stock is priced at $75 while the stock warrant is priced at $5, an investor with less capital would choose to buy a warrant. By purchasing the warrant, an additional source of capital is offered to the company. When a company needs funds in the future, the existing warrants could be exercised and there is no need for issuing new equity.
Companies that seem to be heading to bankruptcy could also issue warrants to raise capital to manage fund shortages. Warrants could also be issued with the intent to increase the goodwill of the company among stakeholders. However, holders must carefully exercise a warrant upon proper planning as they can lead to losses.
Types of warrants
Traditional warrants are those that are issued along with bonds/shares of the company. They are also called warrant-linked bonds. These allow the issuer to issue the security at a lower coupon/interest rate. These warrants are detachable, that is, the warrant could be separated from the bond and sold separately in the secondary markets before the expiration date.
Wedded or wedding warrants
Wedded or wedding warrants are warrants that are not detachable. This means that the underlying security must be bought or surrendered to exercise the warrant.
Covered or naked warrants
Covered or naked warrants are derivatives that are issued by financial institutions instead of companies. Therefore, no bonds or stocks are issued along with the warrants. Unlike normal warrants, underlying securities could be more than equity or bond. This includes currencies, commodities, and other financial instruments.
- The warrant is long-term in nature and could be held for years before actually purchasing the stock. In this holding period, the share price could grow larger and surpass the strike price. Given that the companies perform better over the long run, investing in this derivative is extremely beneficial.
- A warrant is also a low-cost alternative to options. The warrant is a lot cheaper than purchasing the share itself. Individuals with low funds could grasp the investment opportunity by buying the warrants. Therefore, a warrant allows the holder to purchase shares when feasible.
- Issuing warrants at the verge of insolvency or bankruptcy is extremely unethical. Therefore, companies cannot use it to raise additional capital at the time of need.
- Warrants are not as common as options. Since warrants are not traded like shares, companies may prefer not to issue them.
- The value of a warrant becomes zero once it reaches expiry. Therefore, if it is not used effectively at the right time, it could result in complete loss.
Warrant (Law perspective)
Upon understanding the finance perspective of a warrant, it is helpful to learn a law perspective as well.
In a share and bond warrant, the company and the investors are the most important parties. However, in the case of a law warrant, the county sheriff, police officers, and other law enforcement officers are the most important parties.
In this case, a warrant refers to a written authorization to permit an act that might otherwise be considered illegal. The court issues the warrant to law enforcement officers such as the county sheriff or a police officer. The law enforcement officers holding the warrant must take the necessary actions against the offender. The warrant is issued based on probable cause. The county sheriff’s office generally holds a record of active warrants. Active warrants are those that have been issued based on probable cause and held in a public record with the local law enforcement agency. These warrants can be searched by the public on the website of the local law enforcement agency using information such as the first or middle or last name of the wanted person. There can also be outstanding warrants on the website where the wanted person is intentionally hiding from law enforcers.
Historically, warrant information was unclear providing law enforcement officers no limit on authority. Over the years, clear information such as the date of issue, the reason for the issue, and the reason to apprehend an individual or property were included. Warrant information also includes the name and signature of the judge along with the first and last name of the offender.
The warrant issued by the court could be an arrest warrant, a search warrant, possessory warrant, or an execution warrant. The issue of an arrest warrant allows a police officer to apprehend an individual. Issue of a search warrant may allow a police officer or a county sheriff to search inside a property. A possessory warrant may be issued for orders to deliver the property to a person. Finally, the issue of an execution warrant may allow the death of an individual.
Context and Applications
This topic is significant in the professional exams for both undergraduate courses & postgraduate courses and competitive exams, especially for:
- Masters in Business Administration (Finance)
- Bachelor in Business Administration (Finance)
- Master in Science in Investment Management
Question 1: What is the price of going long or short on the underlying security?
- Fair Price
- Bond Price
- Stock Price
- Strike Price
Explanation: The price at which the underlying security is purchased or sold is called the exercise price or strike price.
Question 2: Which of the following is a type of warrant issued by financial institutions instead of companies?
- Naked warrant
- Wedded warrant
- Wedding warrant
- Traditional warrant
Explanation: All warrants except naked or covered warrants are issued by companies generally along with bonds or shares. Naked warrants however are issued separately through financial institutions.
Question 3: Which type of warrants is detachable from shares and bonds?
- Naked warrant
- Covered warrant
- Wedding warrant
- Traditional warrant
Explanation: Warrants are generally issued along with shares or bonds. However, in the case of traditional warrants, the warrants are detachable and can be sold separately in secondary markets before expiry.
Question 4: Under which of the following circumstances is it unethical for companies to issue warrants?
- Immediately after incorporation
- During business expansion
- Verge of insolvency
- Issue of new stock
Explanation: Attempting to raise additional capital on the verge of unfortunate circumstances such as insolvency and bankruptcy is unethical. This also increases the risk for investors.
Question 5: Which of the following is a warrant that allows the death of an individual?
- Execution warrant
- Arrest warrant
- Search warrant
- Outstanding warrant
Explanation: The term ‘execution’ refers to sentencing a person to death. Therefore, an execution warrant allows the death of an individual.
It is incorrect to assume that holding a call warrant to buy common stock in the future provides the holder dividends, opportunities to attend meetings, or the right to vote. Warrant holders cannot have the same benefits as an owner until the shares are purchased. It only provides the holder with the leverage to purchase shares when profitable.
While studying the warrants, it is important to read the following to get a better knowledge:
- Secondary markets
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