Warrant (finance)

Warrant (finance)

In finance, a warrant is a security that entitles the holder to buy stock of the company that issued it at a specified price, which is usually higher than the stock price at time of issue.

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. For instance, it was a common practice during the height of the dot-com bubble for a landlord of sought-after commercial real-estate to demand warrants from high-tech startups as part of the lease agreement. Frequently, these warrants are detachable, and can be sold independently of the bond or stock.

Corporations issue warrants to enhance the future value of their stock to the people holding it.

tructure and features

Warrants have similar characteristics to that of other equity derivatives, such as options, for instance:
*Exercising: A warrant is exercised when shares are bought through 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. Therefore, the expiry date is the date on which the right to exercise no longer exists.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 broker. But often, warrants are privately held or not registered, which makes their prices less obvious. Once the warrants are in the secondary market, they can then be traded just like a stock. Warrants can be easily tracked by adding a "w" after the company’s ticker symbol to check the warrant's price.

Comparison with call options

Warrants are much like call options, and will often confer the same rights as an equity option and can even be traded in secondary markets. However, warrants have several key differences:

*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.

*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 if not exercised unless the price of the common stock is greater than the exercised price.

* Warrants are not standardized like exchange-listed options. While investors can write stock options on the ASX, they are not permitted to do either with ASX-listed warrants, since only companies can issue warrants, and while each option contract is over 100 underlying ordinary shares, 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.

Types of Warrants

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.
*Equity Warrants: Equity warrants can be call and put warrants.
**Call warrants give you the right to buy the underlying securities
**Put warrants give you the right to sell the underlying securities
*Covered Warrants: A covered warrant is a warrant that has some underlying backing, for example the issuer will purchase the stock before hand 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. It should be noted that they are priced using index points.That is, you deal with cash, not directly with shares.

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 P_0
*Coupon payments C
*Maturity T
*Required rate of return r
*Face value of bond F

:Value of warrants = P_0 - (sum_{t=1}^Tfrac{C}{(1+r)^t} + frac{F}{(1+r)^T}).

Naked

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 underly 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

Third-party warrant is a derivative issued by the holders of the underlying instrument.Suppose Company X issues one million warrants which gives the holder the right to convert each warrant into one share at $ 500. This warrant is company-issued. Suppose, a mutual fund that holds 10,000 shares of X 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.

Government issued

Also, when a government agency issues checks which they are unable to pay (due to lack of money) but are redeemable some point in the future, usually with interest, these are also called warrants. 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 comptroller 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

Traded warrants

* "Traditional" warrant
* Naked warrant
* Exotic warrant
** Barrier warrant
*** Hit-warrant
*** Turbo warrant
*** Snail warrant
* Third party warrants

Pricing

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:
*Intrinsic value: This is simply the difference between the exercise (strike) price and the underlying stock price. Warrants are also referred to as at-the-money or out-of-the-money, depending on where the current asset price is in relation to the warrant's exercise price. Thus, for instance, for call warrants, if the stock price is below the strike price, the warrant has no intrinsic value (only time value - to be explained shortly). If the stock price is above the strike, the warrant has intrinsic value and is said to be in-the-money.
*Time value: Time value can be considered as the value of the continuing exposure to the movement in the underlying security that the warrant provides. Time value declines as the expiry of the warrant gets closer. This erosion of time value is called time decay. It is not constant, but increases rapidly towards expiry. A warrant's time value is affected by the following factors:
**Time to expiry: The longer the time to expiry, the greater the time value of the warrant. This is because the price of the underlying asset has a greater probability of moving in-the-money which makes the warrant more valuable.
**Volatility: The more volatile the underlying instrument, the higher the price of the warrant will be (as the warrant is more likely to end up in-the-money).
**Dividends: To include the factor of receiving dividends depends on if the holder of the warrant is permitted to receive dividends from the underlying asset.
**Interest rates: An increase in interest rates will lead to more expensive call warrants and cheaper put warrants. The level of interest rates reflects the opportunity cost of capital.

Uses

*Portfolio protection: Put warrants allow you to protect the value of your portfolio against falls in the market or in particular shares.
*Low cost
*Leverage

Risks

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 you reach the date of expiration.

ource

* [http://www.incademy.com/training/Covered-Warrants-I/Introduction/1087/10002/ Incademy]
* [http://www.investopedia.com/terms/w/warrant.asp Investopedia]
* [http://invest-faq.com/articles/stock-warrants.html Invest-FAQ]
* [http://www.smartmoney.com/ask/index.cfm?story=19990608 SmartMoney.com]
*Basics of Financial Management, 3rd ed. Frank Bacon, Tai S. Shin, Suk H. Kim, Ramesh Garg. Copley Publishing Company. Action, MA 2004.
*Special Situation Investing: Hedging, Arbitrage, and Liquidation, Brian J. Stark, Dow-Jones Publishers. New York, NY 1983. ISBN-10: 0870943847; ISBN-13: 9780870943843

External links

* [http://www.cboe.com/ Chicago Board Options Exchange]
* [http://www.equityderivatives.com/services/education/glossary.php?code=W Finance glossary by SGCIB]
* [http://www.quamnet.com/marketwarrantsindex.action Warrants traded in Hong Kong] - Information on warrant products traded in Hong Kong
* [http://www.optiontradingpedia.com/differences_between_warrants_and_options.htm Differences Between Warrants And Options] , OptionTradingpedia.com


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