One of the safest and easiest ways of putting up capital, which corporations resort to, is issuing warrants. Warrant, like an option, gives the holder the right but not the obligation to buy an underlying security at a certain price, for a quantity in a future time. The only difference between an option and a warrant is the entity that comes into play, which is the company.
The security represented in the warrant (often equity, however, can be a commodity, index or a currency) is given by the issuing company instead of an investor holding the shares. Companies often include warrants as a part of a new-issue offering to attract investors into buying the security. There are two different types of warrants: a call warrant and a put warrant. A call warrant represents a specific number of shares that can be purchased from the issuer at a specific price, on or before a certain date. A put warrant represents a certain amount of equity that can be sold back to the issuer at a specified price, on or before a stated date.
What it involves
All warrants have a specified expiry date, the last day the rights of a warrant can be executed. Warrants are classified by their exercise style: an American warrant, for instance, can be exercised anytime before or on the stated expiry date, and a European warrant, on the other hand, can be carried out only on the day of expiration. The underlying instrument the warrant represents is also stated on warrant certificates. A warrant typically corresponds to a specific number of shares, but it can also represent a commodity, index or a currency.
The exercise or strike price is the amount that you must pay in order to either buy the call warrant or sell the put warrant. The payment of the strike price results in a transfer of the specified amount of the underlying instrument. The conversion ratio is the number of warrants needed in order to buy (or sell) one investment tool. Therefore, if the conversion ratio to buy stock XYZ is 3:1, this means that the holder needs three warrants in order to purchase one share. Usually, if the conversion ratio is high, the price of the share will be low, and vice versa.
How much you can gear
An important element to watch out in a warrant is the gearing factor. This factor would be one that would give you a picture of the extent to which you can incur gains or losses. Higher the number, higher the possibility of gains or losses.
Let’s say that a company ‘X’ shares are currently priced on the market for Rs 1.50 per share. In order to purchase 1,000 shares, an investor would need Rs 1,500. However, if the investor opted to buy a warrant (representing one share) that was going for Rs 0.15 (in the Indian context 10% of the share price) per warrant, with the same Rs 1,500, he or she would be in possession of 10,000 shares instead. Because the prices of warrants are low, the leverage and gearing they offer is high. This means that there is a possibility of greater gains and, also losses. While it is common for both a share price and a warrant price to move in parallel (in absolute terms) the percentage gain (or loss), will be significantly varied because of the initial difference in price. Warrants generally exaggerate share price movements in terms of percentage change.
Let us look at another example to illustrate these points. Say that share XYZ gains Rs 0.30 per share from Rs 1.50, to close at Rs 1.80. The percentage gain would be 20%. However, with a Rs 0.30 gain in the warrant, from Rs 0.15 to Rs 0.45, the percentage gain would be 60%. In this example, the gearing factor is calculated by dividing the original share price by the original warrant price: Rs 1.50/Rs 0.15 = 10. The ’10’ is the gearing factor, and the higher the number, the larger the potential for capital gains (or losses).
Things you need to be aware of
Warrants are transferable certificates, and they emerge as more attractive for medium-term to long-term investment horizons. Considering their very nature (high risk, high return investment tools) warrants remain to an extent unexploited in investment strategies. However, warrants are an attractive option for speculators and hedgers. Warrants also offer a viable option for private investors as well. This is because the cost of a warrant is usually low, and the initial investment needed to command a large amount of equity is virtually quite small.
When it works
Warrants, as an investment tool, present handsome gains to an investor during a bullish phase of the market. It can also offer some protection to an investor during a bear market. This is because as the price of an underlying share begins to drop, the warrant may not realise as much loss because the price, in relation to the actual share, is already low. However, due to the element of leveraging and gearing, warrants carry a few disadvantages.
If we reverse the outcome of the example from above and realise a drop in absolute price by Rs 0.30, the percentage loss for the share price would be 20%, while the loss on the warrant would be 60%.
Another disadvantage and risk to the warrant investor is that the value of the certificate can drop to zero. If that were to happen before it is exercised, the warrant would lose any redemption value.
Finally, a holder of a warrant does not have any voting, shareholding or dividend rights. The investor can therefore have no say in the functioning of the company, even though he or she is affected by any decisions made.
Warrants can offer a smart addition to your portfolio, but due to their risky nature, you need to be attentive and vigilant of the market movements. However, you as an investor can use this instrument as a good diversification option, instead of resorting to complex investment instruments that offer lesser room for diversification though a potential for greater gains.
