What Are Warrants?
Warrants are a type of financial derivative that provide the right, but not the obligation, to buy or sell a security—most commonly an equity—at a specified price before expiration. This price, known as the exercise price or strike price, is critical to the valuation of warrants. American warrants can be exercised at any point prior to expiry, while European warrants can only be exercised on the expiration date. Warrants granting the right to buy a security are known as call warrants, and those allowing the right to sell are called put warrants.
Key Highlights
- Naked warrants: These are issued on their own without being attached to bonds or preferred stock.
- Varieties of warrants: Traditional, naked, wedded, and covered.
- Complexity in trading: Warrants can be a challenging investment instrument for many investors.
The Mechanism of Warrants
While warrants share certain features with options, several key differences set them apart. Generally issued by the company itself rather than a third party, warrants are frequently traded over-the-counter rather than on mainstream exchanges. Investors are not allowed to write warrants as they can with options. Unlike options, warrants tend to be dilutive. When exercised, they result in the issuance of new stock rather than utilizing already-existing shares, increasing the total number of outstanding shares. Warrants also generally have a longer timeframe between issuance and expiration, often measured in years rather than months. Investors opt for warrants as a way to leverage their security positions, hedge against downside risks, or take advantage of arbitrage opportunities. Even though they do not pay dividends or come with voting rights, warrants remain an attractive financial tool. Though not very common in the United States, they see heavy trading in places like Hong Kong and Germany.
Varieties of Warrants
- Traditional Warrants: Issued as an enticement along with bonds (termed warrant-linked bonds), these allow the issuer to present a lower coupon rate. Often detachable, these warrants can be independently sold in secondary markets before expiry. The detachability also applies when issued alongside preferred stock.
- Wedded or Wedding Warrants: Unlike traditional warrants, these cannot be separated. The investor must surrender the associated bond or preferred stock to exercise the warrant.
- Covered Warrants: Issued by financial institutions rather than companies, covered warrants don’t result in new stock issuance upon exercise. Instead, the issuing institution, owning or being able to procure the underlying shares, covers them. These can be linked not just to equities but also to currencies, commodities, or other financial instruments.
Discovering Derivative Warrants
Finding and trading warrants can be difficult, as most of them aren’t listed on major exchanges and free information isn’t readily available. When listed on an exchange, their ticker symbols often appear with an appended ‘W’ for the warrant. For example, Abeona Therapeutics (ABEOW) on Nasdaq. Different issuances may also have different symbol appendages like ‘Z’ or sequential letters like ‘A’, ‘B’, ‘C’. Warrants typically trade at a premium subject to time decay as the expiration date approaches. They can be evaluated using pricing models like the Black-Scholes model.
Differences Between Derivative Warrants and Options
Both derivative warrants and options give the holder the right to buy or sell shares at a set price before a defined date. However, options are listed on exchanges and traded between investors, whereas warrants are directly issued by the company.
Key Questions Answered
What Makes Derivative Warrants Dilutive?
Derivative warrants are dilutive because they introduce additional shares when exercised, diluting the ownership percentage of existing shareholders. If a warrant enabling the purchase of 1 share in a company with 10 outstanding shares is exercised, the total number of shares increases to 11, consequently reducing the percentage stake of all other shareholders.
What Happens If a Warrant Expires?
Expired warrants become worthless if they’re not exercised before their expiration date. The holder loses the right to buy shares in the issuing company.
Why Choose Derivative Warrants Over Options?
Although complex, derivative warrants offer some distinct advantages over options, such as longer expiration timelines and their frequent attachment to already valuable securities like bonds.
The Final Word
Though derivative warrants are a specialized and complex type of financial instrument, they offer unique opportunities for investors. They come with the potential to buy shares but require diligent research and can involve significant trading costs.
Related Terms: options, futures, derivatives market, financial instruments.
References
- U.S. Securities and Exchange Commission. “Abeona Therapeutics Inc. Prospectus”, Page 5.
