Investors have access to various financial instruments for trading and investing in Indian markets. A few of these options are purchasing and selling stocks, mutual funds, and trading in derivatives – including futures and options. But apart from this, there is another instrument available in the market that is not very common amongst investors. This handy, less known instrument is a company warrant.
Though warrants are not very popular and hence unexplored by many stock market participants, they undoubtedly have their inherent benefits. These benefits make warrants pretty useful for a particular type of investor. Understanding stock warrants gives an upper edge to the investors – it gives the investors the ability to be armed with knowledge which can then be used judiciously as and when needed.
What are warrants?
Before we understand warrants, it is crucial to remember that warrants are not much different from call options. Warrants empower the investors with the right to buy securities in the company at a specified date somewhere in the future, at a price determined by the parties today. It is worth noting that such a contract grants a right and not an obligation to execute the contract in the future.
Understanding warrants with an example
Let us take an illustration of a company stock trading at Rs.100. Now, an investor buys a warrant from this company at a strike price of Rs.120 that is exercisable after one year. This warrant gives the right without any obligation to the holder to buy shares for a price of Rs.120 after one year. Let’s say the warrant cost the purchaser Rs. 5 and that she decides to acquire 10,000 shares of the company. The holder and the company can mutually decide the lot size. Warrants become a handy tool for an investor in a bull market to take up a long position in the company over a more extended period. The investor is not required to invest the total capital upfront.
On the other hand, the deal’s downside is limited to the warrant price, which is Rs.5 in the example taken above. This amount is what the investor loses if she does not exercise her right to the warrant at the expiry date.
If the stock has not performed well and is trading at a discount to the strike price, for instance, it is trading at Rs.80; then the investor can let the warrant expire without exercising her right. In such an event, the investor must forfeit the warrant price paid of Rs.5.
How are warrants different from options?
So, as we can see, warrants are similar to call options, but there are specific underlying differences. Let us go through these differences one by one.
1) Warrants are issued directly by the company
Unlike options, which are issued and traded on a stock exchange, here, the fundamental difference is that warrants are issued by the company directly. The primary reason for issuing warrants is to sweeten a deal for an equity or debt infusion, which the company raises.
Investors like warrants because they can acquire more company shares as the company grows. The company also benefits from the advantage of reduced cost of financing. At the same time, warrants assure additional capital if the stock does well. So, it is a win-win scenario for both the investor and the company.
2) Maturity or expiry dates of warrants
Warrants are generally issued for significantly long periods. Unlike options, which have a monthly expiry, warrants can have expiry terms ranging from a few months to even a few years. It is not unusual in the investing world to see warrants with maturity periods of 5 or 10 years.
3) Dilution of company stock
The above point is the biggest differentiator between call options and warrants. In most options traded on Indian exchanges, the right to buy or sell the underlying shares is hardly ever exercised as the options are squared off before expiry. Assuming that the right is exercised, the shares that change hands are already listed on the exchange. Whereas, in the case of warrants, when the investor exercises this right to buy shares, the company has to issue new stock resulting in dilution of equity.
How are warrants priced?
The price of the warrants fluctuates as the price of the share changes. Moreover, a warrant’s price also depends on the time left for expiry. Although the warrants are not actively traded on the exchanges, they are transferable. So, just like options, the price of a warrant comprises intrinsic and extrinsic value.
Investors can sell warrants to any third party, and the buyer and the seller determine the price. This determination is based chiefly on the intrinsic and extrinsic value of the underlying share and the implied volatility.
Are there any downsides to warrants?
Warrants do have their flavour and characteristics. But investors need to be cautious that warrants do not give any voting right to the holder. Only when the warrants are exercised and the shares are allotted to the investor may they get the desired voting right. Similarly, warrants also do not allow the investor to enjoy the benefits of any dividend declared by the company.
So, while understanding warrants stocks, an investor needs to remember that warrants give the advantage of taking a long position in a security over a more extended time frame. This benefit comes with just a marginal investment limited to the warrant price. But, at the same time, the investor can lose that investment if the warrant is not exercised.
Warrants are essential financial tools that when used prudently, can result in a great advantage for the investor.