Many investors use derivatives to hedge their portfolio or speculate on the market. One derivative that an investor can use is warrants. In this article we discuss what this is, how this product differs from option,s and they reasons why warrants may be used.
Definition
A warrant is another form of derivative which is similar to an option but has some different characteristics. Similarly, to an option it gives the buyer the right not the obligation to buy or sell a security at the strike price and at a future expiry date. This is the case for a European warrant. For an American warrant, they can be exercised on or before the expiration date. The underlying instrument in a warrant can be shares or an index.
Call Warrant – this is a product which gives the investor the right to buy the share or index at a specified price on the expiry time (European) or any time before the expiry date (American).
Put Warrant – this is a product which gives the investor the right to sell the share or index at a specified price on the expiry date (European) or any time before the expiry date (American).
Warrants can be physically settled or cash settled. Physically settled means the investor receives the underlying instrument when the investor exercises the warrant. Cash settled means the investor receives the difference of price between what the closing price and the exercise price of the underlying instrument. Cash settlement would be applicable for index warrants.
Benefits of warrants
Investors can use warrants to hedge their portfolio positions. That is, they can take out a put warrant to sell the shares at a specified price if they are concerned about stock price falls. If the puts are not exercised, then the investor only loses the capital outlay of the warrant purchase.
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Warrants offer leverage which means a small outlay in capital could reap a large reward as a small change in the price of the underlying asset can result in large changes in the warrant value.
Investors of instalment warrants can receive the benefits of owning the underlying security such as receiving the dividend or franking credits without owning the physical underlying stock. This could mean the investor is receiving these benefits for a small outlay compared to security holders.
How they differ from options
Warrants have longer expiry dates compared to options. Options have an expiry date of up 5 years where as warrants have an expiry date of up to 15 years.
When an investor receives shares from their equity warrants, these are newly issued shares from the company. When an investor receives shares from their options, these are shares which have already been issued.
Investors cannot write warrants the way they do with options. That is, they cannot use options to short sell. With options an investor can choose to be a seller of an option where they receive the premium for the options but they are forced to buy or sell the stock at the strike price.
They can be issued and structured by an investment bank or domestic banks whereas options are issued by the ASX.
Lauren Hua is a private client adviser at Fairmont Equities.
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