Meaning and definition of warrant
A warrant refers to a derivative security which provides the holder with the right to purchase securities (generally equity) from the issuer at a particular price within a specific period of time. Warrants are generally included in a fresh debt issue as a “sweetener” to inveigle investors. They can also be used for enhancement of the bond yield thus making them more attractive to prospective buyers.
As explained by Investopedia, the primary difference between warrants and call options is that warrants are issued and guaranteed by the company while options include exchange instruments and not issued by the company. Moreover, the lifetime of a warrant is quantified in years, whereas the lifetime of a specific option is quantified in months.
Structure and features of a warrant
The key features of a warrant include:
- Premium: The premium of a warrant represents the extra amount to be paid for shares while purchasing them through the warrant as contrasted to purchasing them in a regular way.
- Gearing (leverage): Gearing of a warrant is the method of ascertaining the level of exposure to the underlying shares through the use of warrant as contrasted to the exposure accessible when these securities are purchased through the market.
- Expiration date
This is the date of expiry of the warrant. Putting it simple, the expiry date refers to the date on which the right to exercise ceases to exist.
- Restrictions on exercise
Akin to options, there are various exercise types related to warrants such as American style, wherein the holder can exercise anytime before expiration or the European style wherein the holder can exercise only on expiration date.
Uses of a warrant
The main uses of warrant include:
- Portfolio protection – the warrants enable the owner to protect the value of owner’s portfolio against the declines in the market or in certain shares.
- Low cost
Risks involved in a warrant
There are some risks implicated in trading warrants. The most important one includes time decay. This implies that the “time value” diminishes with passing time. Moreover, the rate of time decay increases the closure to the date of expiration.