Stock Warrants are derivatives like Options that give a right but not an obligation to the holder to purchase stocks at a specific date with a set price. The investor in these derivatives can exercise the right to fully subscribe to the shares or let them lapse.
Warrants are different from Options in a few ways. A key difference is that warrants are issued by the company itself and they’re not issued by stockholders on stock exchanges like options. These derivatives can have different variations and can be issued for different purposes, the prime objective is to raise new capital.
Stock warrants give the holder a right to buy stocks at a set price and date in the future. The holder of the warrant does not have the legal obligation to buy the stocks though.
They can be issued separately to raise new capital. Warrants can also be issued in conjunction with bonds, for instance, in the form of preferred stocks. The warrants are issued with longer maturity periods, unlike options. Warrants can be exercised until the expiry date only.
How Do Stock Warrants Work?
A company can use several methods to raise new capital from the market. It is one of such methods to attract new investment. A company issues it with a set stock price, expiry date, and characteristics of the issue.
When an investor subscribes it the company issues a warrant certificate. However, the investor does not hold the ownership rights in the company with a warrant certificate, unlike a direct stock purchase.
It is priced lower than a stock price to attract investment. For instance, if a company’s current stock price is $50, It can be issued at $10. It is more likely to attract new investment than calling for investment in stocks.
These derivatives can be issued in a combination with other securities such as bonds or stocks. It is a good example of a “sweetener” in the finance terminology. In addition, it can give rights to investors to buy any number of stocks in the future according to the prevailing stock prices.
Types of Stock Warrants
By functional features, these derivatives are either a put warrant or a call warrant. It can embed different features that can be categorized in several ways.
A call warrant gives a right to the investor to buy stocks at a specified price before the exercise date. Call warrants are often issued as detachable warrants along with bonds or stocks to attract more investors. Investors use call warrants to speculate against rising share prices in the future.
Call warrants come with a longer expiry date. Call warrants are a cheaper source of finance for any company as compared to high-interest debt. Investors can also make profits with call warrants if the share prices increase in the future. These are also less risky investments as compared to Options, as these instruments have more time decay.
A put warrant gives a right to the investor to sell stocks at a specified price before the expiry date. Investors speculate the falling prices of a stock when they invest in put warrants.
A put warrant is also used as a hedging instrument much like a put option. Investors can hedge their positions with put warrants if they speculate falling share prices in the future. However, put warrants are extremely difficult to exercise as compared to put options as these are issued by the same company that owns stocks.
Special Considerations with Stock Warrants
It comes with similar features as stock options. These instruments offer several benefits to investors and the issuing company.
Here are some key points to remember with these derivatives.
- Investors do not hold ownership until they exercise it.
- Warrants are issued by the company and cannot be issued by investors in the stock market.
- Companies issue it to reduce their cost of borrowings.
- Investors need to make a cash investment at the exercise time to own shares at a specified price set in the warrant.
- If share prices do not move up and the investors do not exercise the warrant, they lose their initial investment too.
Advantages of Stock Warrants – For Investors and Issuers
It offers several benefits to investors and issuers:
- Cheaper source of financing for issuers
- Unlimited profit potential for investors
- They come with a set expiry date, exercise price, and duration
- Investors can exercise warrants to own stocks in a company
Disadvantages of Stock Warrants – For Investors and Issuers
It can offer some limitations to both parties as well:
- Investors can lose initial investment in warrants if they do not exercise warrants.
- Warrants can be only issued by the company owning stocks.
- Warrants are not liquid instruments as they are traded amongst investors usually.
Stock warrants give the holder a right to buy stocks at a certain time, price, and duration. The investors do not own stocks until they exercise warrant rights. These are a cheaper source of financing for issuers. Investors can make substantial profits if the stock prices move favorably.