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A warrant is a derivative instrument which gives the warrant holder a right to buy the underlying stock at a pre-determined strike price. A warrant holder can exercise the warrant to buy the stock of the issuing company at an attractive price at a later date. It is basically a discount to the market price of the company’s stock. Warrants are issued by the companies along with a debt or preferred stock issue. It makes the yield attractive for potential debt investors. Warrants are usually traded OTC. Financial institutions also issue warrants where the underlying assets can be currencies, commodities, interest rates etc.
Warrant vs Call Option
A warrant is similar to a call option with some differences as explained below:
- A warrant is issued by the company whose stock is the underlying for the warrant. A call option can be written by anyone trading on the exchange. This limits the open interest of the warrant to the number issued initially by the company. Whereas, the open interest of a call option can be anything depending on demand and supply.
- A warrant is dilutive. When a warrant is exercised, the company issues new shares to the warrant holder. A call option is not dilutive. A call option is settled with the existing market float or by cash.
- A warrant has a life running into double digit number of years. It is common for warrants to have a life of ten years. On the other hand, call options have a life of a few months with longer maturity LEAPs running into a maximum of two to three years.
- A warrant has an inherent conversion ratio fixed at the time of issue. Conversion ratio is basically the number of shares that will be issued to the warrant holder when he exercises the warrant. A call option trades in market lots which are determined by the exchange. One market lot can be for hundreds of shares. The size of the market lot can be varied by the exchange based on the price of the underlying and the liquidity of the options.
- Warrants are less liquid and are not generally traded by retail traders. Call options are highly liquid and are traded heavily by the retail traders.
Characteristics of a Warrant
A warrant is identified by the following characteristics:
- Issuance: A warrant can either be issued by a company or a financial institution. A company can issue warrants for its own stock while a financial institution can issue warrants for a variety of underlying assets.
- Exercise: A warrant can either be exercised at the end of expiry or can be traded independently of the debt instrument with which it was issued.
- Life: A warrant usually has a life running from 10 to 15 years. American type warrant can be exercised anytime during its life while a European type warrant can only be exercised at the end of its life.
- Premium: A warrant is an option like an instrument and hence has a premium attached to it. Premium is the price that the holder pays for the privilege of exercising the warrant at a suitable time.
- Leverage: A warrant is a derivative instrument and has a leverage attached to it. A holder with $100 worth of warrants will have more exposure to the underlying stock than a holder with $100 worth of shares.
Types of Warrants
Depending on its characteristics, a warrant can be classified into following types
A detachable warrant can be detached from the debt or preferred stock instrument along with which it was issued. It can be traded independently from the debt or preferred stock instrument.
A wedded warrant can’t be detached from the debt or preferred stock instruments. A warrant holder has to surrender the wedded instrument too if he has to exercise the warrant.
A naked warrant is issued by the company without issuing a debt or preferred equity instrument in conjunction.
Normal warrant instrument is dilutive because new shares are issued upon exercise. A covered warrant is issued by a financial institution which already owns the underlying shares and hence is non-dilutive as no new shares need to be issued upon exercise.