4.1 Introduction
A warrant is an equity-like security that entitles the holder to buy a pre-specified amount of common stock of the issuing company at a pre-specified per share price (called the exercise price or strike price) prior to a pre-specified expiration date. A company may issue warrants to investors to raise capital or to employees as a form of compensation. The holders of warrants may choose to exercise the rights prior to the expiration date.
A warrant holder will exercise the right only when the exercise price is equal to or lower than the price of a common share. Otherwise, it would be cheaper to buy the stock in the market. When a warrant holder exercises the right, the company issues the pre-specified number of new shares and sells them to the warrant holder at the exercise price.
Warrants typically have expiration dates several years into the future. In some cases, companies may attach warrants to a bond issue or a preferred stock issue in an effort to make the bond or preferred stock more attractive. When issued in this manner, warrants are known as sweeteners because the inclusion of the warrants typically allows the issuer to offer a lower coupon rate (interest rate) on a bond issue or a lower annual fixed dividend on a preferred stock issue.
Companies may also issue warrants to employees as a form of compensation, in which case they are referred to as employee stock options. When warrants are used as employee compensation, the goal is to align the objectives of the employees with those of the shareholders. Many companies compensate their senior management with salaries and some form of equity-based compensation, which may include employee stock options.
4.2 Example of How Warrants Work
Companies may sell warrants directly to customers or distribute them to staff as a perk, but the great majority of warrants are "attached" to freshly issued bonds or preferred shares.
If Company XYZ issues bonds with warrants attached, each bondholder may receive a Rs.1,000 face value bond as well as the opportunity to purchase 100 shares of Company XYZ stock for Rs.20 per share. Warrants normally allow the holder to buy the issuer's common stock, but they can also be used to buy the stock or bonds of another company (such as a subsidiary or even a third party).
The exercise price or strike price is when a warrant holder can acquire the underlying securities. The exercise price is typically higher than the stock's market price when the warrant is issued. The exercise price in our case is Rs.20, which is 15% more than the stock price of Company XYZ at the time the bonds were issued. As the bond matures, the exercise price of the warrant frequently climbs on a set schedule. The bond indenture specifies this schedule.
4.3 Detachable Feature of A Warrant
Warrants are frequently detachable, which is a significant feature. For example, if an investor has a bond with warrants attached, they can sell the warrants while keeping the bond. Warrants can be bought and sold on all of the main stock markets.
When warrants are issued with preferred stock, investors may not receive a dividend as long as they hold both the warrant and the preferred shares. As a result, it may be desirable to detach and sell a warrant as soon as feasible to get dividends.
If the stock price is higher than the exercise price of the contract, the warrant must have a minimum value. Consider the warrants to buy 100 shares of Company XYZ at Rs.20 per share at any point over the next five years. If Company XYZ shares climbed to Rs.40 during that time, the warrant holder may buy them for Rs.20 a piece and sell them for Rs.40 on the open market, making a profit of (40 - 20) x 100 shares = Rs.2,000 on the open market. As a result, each warrant has a minimum value of Rs.20.
It’s worth noting, though, that if the warrants were still valid for a long period, investors would anticipate that the stock price of Company XYZ could rise even higher than Rs.100 per share. Because of this speculation and the additional time for the stock to increase further, a warrant with a minimum value of Rs.20 might easily trade above Rs.20.
However, as the warrant approaches expiration (and the chances of the stock price rising in time to boost profits further diminish), the premium will decrease until it equals the warrant's minimum value (which might be 0 if the stock price falls below Rs.20).
4.4 Types of Warrant
Call Warrant
A call warrant gives the holder of the investment the right, not the obligation, to purchase the underlying financial securities at a specific price on or before a certain date.
If the holder does not exercise the warrant, the call warrant will expire worthless. If the price of the underlying security goes up in value, it means the value of the warrant will also increase. As a result, the holder will earn profit only if he/she expects the price to move higher.
Call Warrant Example
Company ABC is trading at Rs100 per share and decides to raise Rs.1 million in capital. The company would then finance at a price below the market rate of Rs.100 per share to say Rs. 90 per share. As part of the financing, those who participate will receive a warrant as well; let's price it at Rs.120.
If ABC's stock trades above Rs.120 a year later, say at Rs.130, the holder of the warrant reserves the right to purchase shares at Rs120. While they would need to lay out Rs.120 per share to buy, they are automatically making Rs.10 profit per share, when they sell.
Put Warrant
Warrant that grants the buyer the right to sell a certain quantity of a particular underlying instrument at a predetermined strike price on or before a specified date.
An investor who buys a put warrant expects that the price of the underlying instrument will fall during the exercise period. Thus, he acquires the right to sell a particular quantity of the security in question at an agreed-upon price. The put writer is obligated to buy the underlying instrument at this price, and in return receives a premium from the put holder. However, most warrants are settled in cash rather than through the physical delivery of the underlying security.
4.5 Stock Warrant vs. Stock Option
A stock warrant should not be confused with a stock option, as a stock warrant is directly issued by the company to the investor, while a stock option is a contract between two people. Similarly, a call option gives the investor the right to buy a stock at a specified time and price, while a put option gives the right to sell at a specified time and price.
Stock warrants are designed to help raise capital, encourage investors to invest, and create long-term interest in the stock of companies. They are also appealing to those investors who believe that a company offers an attractive long-term potential.
Difference between Options Vs Warrants
The option is an agreement wherein buyers possess the right but not the obligation to buy or sell stock at a specified price and date. Conversely, a warrant is an instrument registered to provide the buyer the right to get a specified number of shares at a pre-decided date and prices.
Options are standard contracts and are required to adhere to rules governing maturity, duration, size of the contract, and exercise price, whereas warrants are securities (non-standardized), making it flexible.
Options are issued by the exchange, such as NSE & BSE, whereas warrants get issued by a specific company.
A stock option is a secondary market instrument as trading takes place between investors, whereas a warrant is a primary market instrument since it is issued by the company itself.
In options trading, the selling party writes the options while warrants have a single issuer responsible for the rights offered.
The maturity period also differs with options having until two years and warrants having a maturity of 15 years.
The underlying assets with respect to options are Domestic shares, bonds, and indices, whereas warrants shall have securities such as Currencies and international shares.
In terms of making a profit, the company does not receive any direct benefit, which ultimately is passed on to the investor. Conversely, the issue of warrants is to encourage the sale of shares and offer a hedge against fall in the value of the firm, which can lead to a dip in the share price of the company.
Options do not involve the issuance of new stock, but warrants result in dilution creating issuance of new stock.
Trading in options involves following principles of a futures market, and warrants follow the principle of cash markets.
Options can be issued independently, but warrants are combined with other instruments, such as bonds.
4.6 Similarities Between Options & Warrants
Both instruments offer the holders an opportunity to enhance their exposure and take advantage of the stock market movements without possession of the asset.
They confer on their holders the right to purchase a specific quantum of the principal asset at a fixed price and specified date.
Both represent a right and not any control over the principal asset unless it has been exercised.
Factors influencing the value of an option or a warrant are the same such as the Underlying stock price, strike price, or the Exercise Price, Time to expiry, implied volatility, and risk-free interest rate.
Both have the same components in terms of pricing, i.e., Intrinsic Value andTime Value of money. It is to be noted that.
Intrinsic value is the difference between the price of the principal stock and the exercise or strike price. This value can be Zero but never negative.
Time value is the difference between the price of the option/warrant and its intrinsic value.
