All About Warrants

Submitted by Sharemarket News on 1 July, 2011 - 18:42

Everything about warrants.

For the investor who wants to diversify their portfolio, warrants provide an alternative way to be exposed to assets such as shares. On top of a new security, companies will often issue warrants as an added attraction for buyers.

What are Warrants?

Warrants are like options, a form of equity derivative. A derivative is a security whose price is dependent on an underlying asset. Like options, warrants are contracts rather than actual shares or stocks. Under the contract, warrants give the owner the right to trade (buy or sell) underlying securities to the issuer. Other warrants allow holders to get a cash payment related to the value of the underlying instrument at a specified time. Warrant price is determined by market conditions and the price of the underlying asset.

What is the difference between warrants and options?

Options are exchange instruments of the Australian Stock Exchange; they are not issued by a company. A typical option has a lifetime measured in months. Warrants are issued and guaranteed by the company and usually has a lifetime of years.

What are the Features of Warrants?

There are several types of warrants, with features varying depending on the issuer. The Product Disclosure Statement (PDS) sets out the conditions of the warrant in detail. In general, standard warrant features include underlying (security), call or put, settlement method, exercise price (final payment), expiry date, and conversion ratio. Non-standard features include barrier, caps and covered. Let's take a look at each feature.

  • Underlying Instrument. Underlying instruments such as share, index, currency or commodity are issued against warrants. Depending on the terms of the warrant, you can either trade (buy or sell) the underlying instrument or get the cash equivalent upon expiration date.
  • Call or Put. A warrant can be call or put. A call warrant means you have the right to buy a certain amount of the underlying instrument from the issuer while a put warrant allows you to sell a certain amount of the underlying instrument to the issuer on or before the specified date.
  • Expiration Date. Trading and your right to exercise the warrant stops on the expiry date. On this date, the issuer needs to deliver or take delivery of the underlying instrument; otherwise, he needs to make a cash payment according to the warrant terms.
  • Settlement. There are two ways to settle warrants. One is through delivery and the other is through cash settlement. Deliverables are settled by transfer of underlying assets. Cash settlement is settled by a cash payment from the warrant issuer to the holder. In the case of in-the-money warrants, the exercise price of the warrant less the current price of the underlying asset is paid to the holder. A warrant that is in-the-money means it has intrinsic value (always greater than or equal to zero).
  • Exercise Price (Final Payment). The amount of money that is due when the warrant is exercised is called the final or strike price. The warrant holder pays the issuer in a call warrant, and the issuer pays the warrant holder in a put warrant. The exercise price can be fixed or variable. Exercise price is generally fixed at the time of issue, but price can be adjusted with self-funding and rolling instalment warrants. If a shares split or a bonus issue happens during the warrant's life, the exercise price may be also be adjusted. The standard warrant denomination is Australian dollars, with the exception of some currency and commodity warrants. The exercise price of index warrants are expressed in points.
  • Exercise Style. Warrants can be use either the American style or European style. You can exercise an American-style warrant at any time during its life, but you have to wait until the expiration date to exercise a European style warrant.
  • Conversion Ratio. A conversion ratio is the number of warrants needed to buy or sell one investment unit. For example, if the conversion ratio to buy sock MRU is 3:1, the holder needs three warrants to buy one share. In general, a high conversion ratio means low share price, and a low conversion ratio means a high share price. This means that a warrant with a 2:1 conversion ratio should trade at about half the price of a warrant with a 1:1 conversion ratio.

    When comparing different warrants, it is helpful to take into account conversion ratio on a "per share" basis on top of features like expiry date and exercise price. To compare on a per share basis, multiply warrant price by warrant conversion ratio. Let's say warrant A and B has the same exercise price of $25. Warrant A has conversion ratio of 1:1 and price of $0.70, while warrant B has conversion ratio of 2:1 and a price of $0.36. Warrant price on a per share basis is $0.70 for warrant A, and $0.72 for warrant B.

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