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.
Structure
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, basically, a warrant issued
in a foreign currency. They can prove to be a flexible tool.
- 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 P0
- Coupon
payments C
- Maturity
T
- Required
rate of return r
- Face value
of bond F
- Value of
warrants =
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
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.
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