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?

Here are some key points about warrants:

1. Derivative security:
– 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.

2. Issuer of warrants:
– Warrants are often issued by companies as a way to raise additional capital. They can also be issued by financial institutions, governments, or other entities.

3. Exercise price:
– The exercise price, also known as the strike price, is the price at which the warrant holder can buy the underlying stock. This price is predetermined and specified in the warrant.

4. Expiration date:
– 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.

5. Leverage:
– Warrants 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.

6. Call warrants vs. put warrants:
– A call warrant gives the holder the right to buy the underlying stock, while a put warrant gives the holder the right to sell the underlying stock. Most warrants are call warrants.

7. Transferability:
– 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.

8. No voting rights or dividends:
– Unlike common stock, warrant holders typically do not have voting rights in the company, nor are they entitled to receive dividends.

9. Risk and reward:
– Warrants 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.

10. Speculative nature:
– Warrants are often viewed as speculative investments and are favoured by investors seeking potentially high returns, but they also come with higher levels of risk.

11. Adjustments for corporate actions:
– In the event of stock splits, mergers, or other corporate actions, the terms of the warrant may be adjusted to reflect these changes.

12. Common in initial public offerings (IPOs):
– Warrants are sometimes issued as part of an IPO to entice investors. These are known as “warrant sweeteners” and are designed to make the offering more attractive.

Overall, warrants are a financial instrument that can offer potential opportunities for gains, but they also come with a higher degree of risk. Investors considering warrants should carefully evaluate the terms and conditions, as well as their own risk tolerance and investment objectives.

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 R10 per share within the next five years.

If the price of XYZ Company’s shares increases above R10 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.