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.
Warrants have similar characteristics to that of other equity derivatives, such as options, for instance:
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:
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:
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.
That is, you deal with cash, not directly with shares.
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.
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.
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
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:
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.