What it is:
How it works (Example):
Occasionally, companies offer call warrants (usually simply called "warrants") for direct sale or give them to employees, but the vast majority of call warrants are "attached" to newly issued bonds or preferred stock.
For example, if Company XYZ issued $100 million of bonds with call warrants attached, each bondholder might get a $1,000 face-value bond and the right to purchase 100 shares of Company XYZ stock at $20 per share over the next five years. Warrants usually permit the holder to purchase common stock of the issuer, but sometimes they allow the purchaser to buy the stock or bonds of another entity (such as a subsidiary or even a third party).
The price at which a call warrant holder can purchase the underlying securities is called the exercise price or strike price. The exercise price is usually higher than the market price of the stock at the time of the call warrant's issuance. In our example, the exercise price is $20, which is probably 15% higher than what Company XYZ stock was trading at when the bonds were issued. The call warrant's exercise price often rises according to a schedule as the bond matures. This schedule is set forth in the bond indenture.
Call warrants are not the same as call options or stock purchase rights. One important characteristic of call warrants is that they are often detachable. That is, if an investor holds a bond with attached warrants, he or she can sell the warrants and keep the bond.
Call warrants are traded on the major exchanges. In some cases where warrants have been issued with preferred stock, stockholders may not receive a dividend as long as they hold the warrant. Thus it is sometimes advantageous to detach and sell a warrant as soon as possible if the investor expects to earn more from dividends.
Call warrants tend trade above their minimum value. For example, consider the warrant to purchase 100 shares of Company XYZ for $20 per share anytime in the next five years. If Company XYZ shares rose to $100 during that time, the warrant holder could purchase the shares for $20 each, and immediately sell them for $100 on the open market, pocketing a profit of ($100 - $20) x 100 shares = $8,000. Thus, the minimum value of each warrant is $80.
It is important to note, however, that if the warrants still had a long time to expiration, investors might speculate that the price of Company XYZ stock could go even higher than $100 per share. This speculation, accompanied by the extra time for the stock to rise further, is why a warrant with a minimum value of $80 could easily trade above $80. But as the warrant gets closer to expiring (and the chances of the stock price rising in time to further increase profits get smaller), that premium would shrink until it equaled the minimum value of the warrant (which could be $0 if the stock price falls to below $20 rather than rising above $100).
Why it Matters:
Warrants are not the same as call options. Call options are not detachable and they often expire far before warrants do (usually less than a year, versus five or more for warrants). For example, if the Company XYZ bond were a convertible bond, the holder could trade the bond's $1,000 par value for a number of Company XYZ shares. But if the Company XYZ bond has a call warrant attached, the investor must come up with additional money to purchase the shares at the exercise price (in this case 100 shares x $20 per share, or $2,000).
Warrants are also not the same as stock purchase rights. The exercise price of a stock purchase right is usually below the underlying security's market price at the time of issuance, whereas warrant exercise prices are typically 15% above market price at the time of issuance.
Securities with attached warrants allow the holder to participate in the price appreciation of the underlying security (Company XYZ common stock, in our example). For example, the price of a Company XYZ bond with a warrant attached tends to rise as the price of Company XYZ common stock approaches the exercise price (similar to a call option).
This opportunity to participate in the upside of another security gives investors some diversification and thus is a way to mitigate risk. As a result, companies often issue bonds and preferred stock with warrants attached as a way to enhance the demand and marketability of the offering. This in turn lowers the cost of capital for the issuer.