CFM11086 - Understanding derivative contracts: types of derivatives

Warrants

A warrant is very similar to an option. The term is normally used to denote an option to subscribe for shares, corporate bonds or other debt instruments. Thus when someone exercises a warrant, the exercise normally results in new financial instruments being created – unlike an ordinary call option, which generally confers the right to buy an existing asset. This means that the exercise of a warrant to subscribe for shares in a company will result in the dilution of existing investors’ shareholdings.

You will often come across warrants attached to fixed-rate bonds. A company may issue bonds with an equity warrant attached – a right to subscribe for shares in the issuing company. These bonds are similar to convertible bonds (see CFM6100), except that the warrant element can be separately traded. This means that an investor subscribing for the bond can make a profit if the company’s share price increases. In return, the investor will be prepared to accept a lower interest return on the bond. So a company can often borrow more cheaply by issuing bonds with equity warrants attached than by issuing straightforward corporate bonds.

A covered warrant is an exception to the general principle that the exercise of a warrant creates a new financial instrument. A covered equity warrant is really a long-dated call option over shares. It is issued by a third party with a substantial holding of the shares of the company in question, so that when an investor exercises the warrant, he or she will receive shares that already exist.