A warrant is a derivative that entitles the holder to buy the underlying stock of the issuing company at a fixed price called exercise price (or strike price) on or before the expiration date. Warrants generally trade at a premium, which is subject to time decay as the expiration date nears. As with options, warrants can be priced using the Black-Scholes model.
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. Frequently, these warrants are detachable and can be sold independently of the bond or stock.
In the case of warrants issued with preferred stocks, stockholders may need to detach and sell the warrant before they can receive dividend payments. Thus, it is sometimes beneficial to detach and sell a warrant as soon as possible so the investor can earn dividends.
Warrants are very similar to call options, for instance:
- Exercising: A warrant is exercised at exercise price when the holder informs the issuer their intention to purchase the shares underlying the warrant.
- 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.
- Leverage: A warrant's leverage 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: 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 ceases to exist.
- Restrictions on exercise: Like options, there are different exercise types associated with warrants such as American style (holder can exercise at any time on or before the expiration date) or European style (holder can only exercise on the expiration date).
Many warrants confer the same rights as equity options and warrants often can be traded in secondary markets like options. However, there also are several key differences between warrants and equity options:
- Issuer: Warrants are issued by private parties, typically the corporation itself, rather than a public options exchange.
- Dilutive: 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.
- Directly: 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.
- Lifetime: A warrant's lifetime is measured in years, while options are typically measured in months. Upon expiration, the warrants are worthless unless the price of the common stock is greater than the exercise price.