Warrants

A warrant is a time-limited right to subscribe for shares, debentures, loan stock or government securities and is exercisable against the original issuer of the underlying securities. It is an interest and dividend-free securities, granting the holder the right to buy (call warrants) or sell (put warrants) a certain underlying security (e.g. shares) at a predetermined price (exercise price) at a future time.

Company warrants are issued by companies on their own ordinary shares to raise capital for themselves. Their value depends on the value of the ordinary share which is the underlying security, which means that a warrant is a derivative product. As such, the warrant investor gains economic exposure to this underlying security without actually owning it.

The value of a warrant is determined by the underlying security price, the exercise price of the warrant, the volatility of the underlying security price, the time to expiry of the warrant, and the interest rate and the dividend yield of the underlying asset.

Investors buy the warrants at a fraction of the price of the underlying security and only upon exercise do they pay for the ordinary shares, when they will know the actual market price of the shares in comparison to the predetermined price that should be paid. Thus, the buyer has the right (but not the obligation) to buy this underlying security at a predetermined price (the Strike or Exercise Price) on or before a predetermined date (the “Expiry” Date).

To exercise a warrant means to exercise the rights attributed by the warrant. Hence, when a warrant holder exercises a warrant, it means that they want to buy the underlying security at the exercise price from the issuer.

The main difference between warrants and call options is that warrants are issued and guaranteed by the company, whereas options are exchange instruments and are not issued by the company. Also, the lifetime of a warrant is often measured in years, while the lifetime of a typical option is measured in months.

A warrant can be exercisable at any time during its life (American-style) or only at expiry (European-style).

Return

The buyer of a call warrant has locked in the purchase price of the underlying security. A return can be achieved if the market price of the underlying security exceeds the agreed exercise price to be paid by the investor. The warrant holder can buy the underlying security at the strike price and sell it immediately at the ruling market price.

An increase in the price of the underlying security will usually lead to a proportionately higher percentage increase in the warrant price (leverage effect). Consequently, most warrant holders achieve a return by selling warrants.

The same applies, in the opposite direction, to put warrants. These usually rise in value if the price of the underlying security decreases.

The return on warrant transactions is not guaranteed and cannot be established in advance.

Main Characteristics

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.
  • Exercise or Strike price: is the amount that must be paid in order to either buy the call warrant or sell the put warrant. The payment of the strike price results in a transfer of the specified amount of the underlying instrument.
  • 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 no longer exists.
  • Restrictions on exercise: Like options, there are different exercise types associated with warrants such as American style (holder can exercise anytime before expiration) or European style (holder can only exercise on expiration date).
  • Call warrant: represents a specific number of shares that can be purchased from the issuer at a specific price, on or before a certain date.
  • Put warrant: represents a certain amount of equity that can be sold back to the issuer at a specified price, on or before a stated date.

Risks

Warrants often involve a high degree of gearing so that a relatively small movement in the price of the underlying securities results in a disproportionately large movement, unfavourable or favourable, in the price of the warrant. The prices of warrants can therefore be volatile.

It is essential for anyone who is considering purchasing warrants to understand that the right to subscribe which a warrant confers is invariably limited in time with the consequence that if the investor fails to exercise this right within the predetermined timescale then the investment becomes worthless. So you should be extremely careful when purchasing warrants which are close to expiry.

Investors should be aware that other factors being equal the value of derivative warrants will decrease over time. Therefore derivative warrants should never be viewed as products that are bought and held as long term investment. (Time Decay)

There are risks such as Liquidity risk, whereby in the face of insufficient buy orders, the market price of the warrant may be affected disproportionately and the warrant holder will not be able to sell his warrants for a reasonable price in the market, and the limited life of warrants due to the expiry date meaning that a warrant may become worthless if the buyer’s expectations are not realized before expiry.

You should not buy a warrant unless you are prepared to sustain a total loss of the money you have invested plus any commission or other transaction charges.

Off-Market warrant transactions: Transactions in off-Market warrants may involve greater risk than dealing in Market traded warrants because there is no Market through which to liquidate your position, or to assess the value of the warrant or the exposure to risk. Bid and offer prices need not be quoted, and even where they are, they will be established by dealers in these instruments and consequently it may be difficult to establish what a fair price is.

In summary the dealing in warrants may involve risks including but not limited to the following: credit risk, inflation risk, market risk, country risk, liquidity risk, leverage risk, exchange risk, interest-rate risk (indirect) and leverage risk.

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