Warrant

Definition

A warrant is a financial instrument that gives the holder the right, but not the obligation, to buy a specific number of shares of a company’s stock at a predetermined price before a certain expiration date.

What is a warrant?

A warrant is a type of derivative security, meaning its value is derived from an underlying asset, which in this case is typically the stock of a company. They are often issued by companies as a way to raise additional capital. They can also be issued by financial institutions, governments, or other entities.

Warrants can be bought and sold in the secondary market, separate from the underlying stock. This means that investors can trade warrants without directly affecting the company’s stock. They provide leverage because they allow the holder to control a larger amount of stock for a relatively small initial investment. This means that the potential gains (or losses) from holding a warrant can be higher compared to owning the stock directly. However, they are considered higher-risk investments compared to owning the underlying stock. If the stock price does not reach the exercise price before the warrant expires, the warrant may expire worthless.

Unlike common stock, warrant holders typically do not have voting rights in the company, nor are they entitled to receive dividends.

In the event of stock splits, mergers, or other corporate actions, the terms of the warrant may be adjusted to reflect these changes. Warrants have a specified expiration date. This is the deadline by which the warrant must be exercised if the holder wishes to buy the underlying stock at the agreed-upon price.

Call warrants vs. put warrants

Call warrants and put warrants are financial derivatives that give the holder the right to buy or sell the underlying asset at a specific price before a certain date.

Call warrants allow the holder to purchase the asset at a predetermined price, typically used when the investor expects the asset’s price to rise. Put warrants, conversely, give the holder the right to sell the asset at a set price, used when the investor anticipates a decline in the asset’s value.

Warrant vs. option

Warrants and options are both financial instruments that give the holder the right to buy or sell an underlying asset at a specified price before a certain date. However, warrants are typically issued by companies as a way to raise capital and can have longer expiration periods. Options, on the other hand, are standardised contracts traded on exchanges and usually have shorter expiration periods. Warrants often lead to the issuance of new shares, diluting existing shareholders, while options involve existing shares and do not affect the number of shares outstanding.

What happens when a warrant expires?

When a warrant expires, it becomes worthless, and the holder loses the right to buy or sell the underlying asset at the specified price. The investor cannot exercise the warrant to purchase or sell the underlying asset after the expiration date, resulting in a total loss of any potential value that the warrant might have had. Therefore, it is important for warrant holders to monitor expiration dates and make informed decisions before the warrants lapse.

Example of a warrant

John purchases shares of XYZ Company, a startup in the technology sector. Along with the shares, John also receives warrants as part of the investment deal.

These warrants give John the right, but not the obligation, to purchase additional shares of XYZ Company at a predetermined price within a specified time frame, typically several years.

For instance, John’s warrants allow him to buy additional shares of XYZ Company at $10 per share within the next five years.

If the price of XYZ Company’s shares increases above $10 during the warrant’s validity period, John can exercise the warrants to buy more shares at the lower predetermined price, thereby potentially profiting from the difference.