A warrant (WT) is a security granting its holder the right to buy (call) or sell (put) a specific amount of an underlying asset either of the instrument’s issuer or of a 3rd-party, usually within a set time period, at a price typically set above the underlying security’s current market price when it is issued. Warrants are highly leveraged instruments, making them very attractive to investors as a speculative tool. While the term “warrant” in the United States generally refers to subscription warrants, in continental Europe it most commonly refers to the covered and puttable warrants issued by banks.
A subscription warrant is a long-dated call option that gives its holder the right to purchase securities from its issuer at a fixed exercise price, generally significantly higher than their current market price, commonly issued with a host instrument (bond or preferred stock) and immediately detachable and traded in the secondary market. The issuer of the warrant is the issuer of the underlying, with the underlying typically being the issuer’s common shares. The effect of a warrant’s exercise is an increase in the issuer’s capital stock and shares outstanding.
A subscription warrant is similar to a traded option with three major differences:
- It is typically issued for longer maturities than options, commonly being exercisable several years after issue of its host instrument;
- It results in the writer’s issuing of new equity; and
- It is not normally subject to strict market regulatory requirements.
The formula for determining the cost of a unit of the underlying when exercising a subscription warrant or other call warrant is, where EC is the exercise cost of buying the underlying via the warrant, WP is the warrant’s premium (price), n is the number of units of the underlying asset (e.g., 100 shares) that can be bought with each warrant, and EP is the exercise price (strike price) per unit of underlying:
EC = (WP/n) + EP
The warrant premium is the percentage difference between the market price of a financial asset (stock, index or basket of shares) and the price paid for that asset when a call warrant is exercised. The warrant premium is calculated as follows, where WP is the warrant premium, EC is the exercise cost of buying a unit of the underlying asset via the warrant, and AP is the underlying asset’s market price (times 100 in the case of warrants on stock):
WP = [(EC – AP)/AP] x 100
The warrant conversion ratio is the number of warrants that must be exercised in order to buy or sell a single unit of the underlying asset:
Warrant Conversion Ratio = Unit of Underlying Asset/Warrants