In the world of finance and investment, the term ‘warrants’ often surfaces, especially when dealing with stocks and bonds. While it may seem complex to comprehend initially, it is a fundamental concept that any serious investor needs to understand.

A traditional (call) warrant, in finance, is a security that gives the holder the right, but not any obligation, to buy a certain amount of underlying common stock of the issuing company at a fixed price, directly from the issuing company, during a pre-defined time period. The fixed price is known as the exercise price.

Call warrants are similar to call options in that they give the holder the right, but not the obligation, to buy an underlying asset. Generally speaking, call warrants tend to have much longer lifetimes than options, i.e. the expiry date is much further into the future when the warrant is issued.

Understanding the Mechanism of Warrants

• Call warrants are typically issued along with a bond or preferred stock and act as sweeteners, making the underlying security more attractive to investors since it comes with a warrant that could yield the buyer an additional profit.
• If the market price of the stock is less than the exercise price, the call warrant is considered ‘out of the money’ and is worthless on the expiry date. However, if the market price of the stock is above the exercise price, the warrant is ‘in the money’, and the holder can gain by exercising the warrant.
• When a call warrant is exercised, the company issues new shares to honor the contract, increasing the total shares outstanding, which can lead to dilution of earnings per share. Warrants are dilutive in nature and this is something investors must take into account. This is an important difference between the warrant and the buy option (call option) and the warrant. For the call option, the underlying security has already been issued. Therefore, call options are not dilutive.

Expiry

• An American-style warrant can be exercised at any time until it has expired.
• European-style warrant can only be exercise on the expiration date.

Traditional warrants vs. naked warrants

Above, we have explained how traditional call warrants work, and how they are issued by a share company in conjunction with the issuing of bonds or preferred shares. There is an exception to this though: the naked warrant. A naked warrant is issued without accompanying bonds or shares.

Unlike normal warrants which are issued with an accompanying bond or preferred share in the issuing company, naked warrants are issued by a financial institution and can be backed by a variety of underlying securities, which makes them a lot more flexible.

Many of the major stock exhanges permit the trading of naked warrants.

Wedded warrants

A wedded warrant is a warrant attached to another security that is not detachable. In order to exercise the warrant, the holder must give up the other security.

Example: You purchase a preferred share in Company A and it comes with warrant. If you want to exercise the warrant, you must surrendered the preferred share.

Harmless warrants

A harmless warrant is a special type of warrant that comes with a provision stating that bondholders must surrender the existing bond if they want to buy the same typåe of bond form the issuer. In essence, the holder can only exercise the warrant by handing in their existing bond and purchasing another bond with similar features from the same issuer. For the bond issuer, harmless warrants are less risky and they are popular among companies that are eager to keep a strict hand on their debt level.

Penny warrants

When the exercise price is set to a very low symbolic amount, such as one penny or one cent, the warrant is known as a penny warrant.

Put warrants

Above, we have focused on call warrants, since they are by far the most common type of warrant. A call warrant gives the holder a right to buy the underlying asset. Put warrants – warrants that give the holder a right to sell – also exist, however.

In essence, a put warrant can be described as a company-issued option to sell back a specified number of common shares to the issuer, for a certain price and during a certain time frame.

Important: If the stock price falls dramatically, the issuing company might be in such dire straits that they will not be able to honor their obligation when you wish to exercise your put warrant. This is not a common occurance, but it is a risk that should be taken into account.