Warrants
This issue’s Offbeat Offering features an obscure product
that gets very little coverage—warrants.
In the U.S. markets, most investors do not actively seek
warrants on their own, but may run across warrants in
conjunction with other holdings, such as certain bonds
and preferred stock, that may have warrants “attached.”
Unattached warrants are more common in foreign
markets.
» How It Works
A warrant gives an investor the right, but not the obligation, to buy a specified amount of an underlying stock
at a certain price and at a future date directly from the
company. It is considered a derivative, which means it
derives its value from the underlying security. The value
of the warrant will always depend on the performance
of the stock.
Warrants are similar to options in that a holder has
the option to buy a stock at a specified price and time.
However, an option is an exchange-created instrument
in which the underlying shares are held by a secondary
investor; when options are exercised, the underlying
shares are bought from the option seller.
Warrants, on the other hand, traditionally are issued
directly by the company, often as an “attachment” to
bonds and occasionally preferred stock. When a typical
warrant is exercised, the shares are bought directly from
the issuing company, meaning new shares are created.
This increases the number of shares outstanding and
causes the value of the shares to be diluted.
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can be exercised). An American warrant can be exercised
anytime on or before the expiry date, whereas a European
warrant can only be exercised on the expiry date.
The exercise or strike price is set at a price above the
current stock price but below the expected future stock
price.
» Types
The most common type of warrant issued is a call warrant, which gives the holder the right to buy stock from
the company at a predetermined price on or before a
specified date.
» How to Trade
A warrant attached to a bond or preferred stock offering can usually be exercised by contacting the company
directly.
Traditional warrants issued by a corporation often remain
privately held. However, warrant holders can detach
the warrant from the bond or stock issue and sell it
either on an exchange or through a private placement.
In addition, some corporate issuers do list warrants on
an exchange.
Warrants sold on an exchange are traded like stock. Typically the warrant ticker symbol contains a “w” after the
stock ticker symbol. A broker is needed to buy or sell
warrants on an exchange.
» When to Exercise
In addition, warrants typically are much longer term
than options, with expirations lasting years instead of
months.
An attached warrant is likely to be exercised when the
actual stock price moves above the warrant exercise price,
meaning the investor can buy the stock at a lower exercise
price and resell it at the higher market price.
Companies will issue warrants for many reasons, one being that adding the warrant is a way to entice investors; it
also allows the company to pay lower interest rates and
dividends due to the added value of the warrant.
In addition, if a company has raised its dividend on
common shares, it might be beneficial to exercise the
warrant to receive the higher dividend payout, since
warrant holders do not receive dividends.
Each warrant will contain a conversion ratio (the number of warrants needed to buy one common share), an
exercise or strike price (the price at which the warrant
is executed) and an expiry date (the last day the warrant
Companies may also issue warrants with “stepped-up”
exercise prices. This means that as the holding period
increases, so does the exercise price. Investors may find
it advantageous to sell prior to a “step-up” if they feel
AAII Journal
the stock may not surpass the new exercise price.
Another issue is the passage of time. Warrants, like
options, tend to lose some value as the exercise date
approaches, since there is less time to exercise the warrant. Once the expiration date passes, the warrant loses
all value if unexercised.
» Investor Suitability
Warrants can increase return potential when attached to
preferred stock or bond offerings.
Investing in unattached warrants, however, is similar
to options investing and requires an understanding of
options behavior and pricing. Many factors influence
pricing, including the underlying stock’s price, volatility, and the amount of time remaining to the warrant’s
expiration.
In addition, purchasing unattached warrants introduces
a certain amount of leverage into an investor’s portfolio.
Because warrants represent only an option to purchase,
they are priced very low relative to the actual stock price,
and a much lower dollar commitment can control a significant stock position. In addition, the warrant’s price
will fluctuate along with the underlying stock price, but
it will typically be much more volatile. And if the underlying stock drops below the strike price, the warrant
can expire worthless.
» Tax Consequences
Investors will pay capital gains taxes on any exercised
warrants, assuming the shares were sold in the secondary
market for a profit. Also, any dividends that were received
from the underlying stock after the warrant was exercised
and before the shares were sold are also taxed.
» The Pros
Issued and Guaranteed by the Company
Traditional warrants issued by a company carry a guarantee that the warrant can be exercised at the stated
price.
Profit Potential
If the stock price moves above the exercise price, investors can buy the stock at the lower exercise price and sell
it at the higher market price. This can add a great deal
of profit potential to an otherwise lower return bond or
preferred stock; for warrants purchased in the secondary
markets, this adds a great deal of profit potential for a
smaller initial investment.
» The Cons
Risks
Warrants tend to be added to bond offerings by small,
start-up firms, which can be risky. The company offers
a lower interest rate on the bonds because the warrant
is seen as an added feature. Bonds of smaller, less established companies usually have lower credit ratings.
The leverage can work against investors in unattached
warrants, adding a greater bite to any losses. The worst
outcome is considerable: a complete loss of the original
investment if the warrant expires with no value.
Dilution of Shares
Because the company must issue new shares when a call
warrant is exercised, the number of shares outstanding
increases, which reduces the value of each share of
stock.
No Shareholder or Dividend Rights
Warrant holders have no voting or dividend rights.
» Additional Information
There is little information available on warrants other than
the specifics contained in the offering filings, available
from the issuing company or through the SEC’s EDGAR database (www.sec.gov/edgar.shtml), or through
a brokerage firm offering the warrant.
Finding a list of warrants is also not easy. The best source
for listings is from the Web sites of the individual stock
exchanges. For the New York Stock Exchange, go to
the Listed Company Directory at www.nyse.com, and
do a search for listed companies by issue type (select
“Warrant”).
For the American Stock Exchange, go to the Symbol
Lookup section at www.amex.com and do a search for
companies containing the word “warrant.”
For NASDAQ, go to the symbol directory at www.
nasdaqtrader.com, and do a search for company names
containing the word “warrant.”
~By Cara Scatizzi
AAII Associate Financial Analyst
June 2007
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