What is a Naked Warrant?

A naked warrant is a warrant that is not attached to a bond or preferred stock.

How Does a Naked Warrant Work?

Warrants are securities that give the holder the right, but not the obligation, to buy a certain number of securities (usually the issuer's common stock) at a certain price before a certain time. Warrants are not the same as call options or stock purchase rights.

Occasionally, companies offer warrants for direct sale or give them to employees as incentive, but the vast majority of warrants are 'attached' to newly issued bonds or preferred stock. Naked warrants, however, are not attached to bonds or preferred stock, and they are usually issued by banks or other financial institutions.

The price at which a 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 warrant's issuance.

Warrants are traded on the major exchanges. They tend to trade above their minimum value. For example, consider the warrant to purchase 100 shares of Company XYZ for $20 per share any time 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 before they expired, 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 Does a Naked Warrant Matter?

Naked warrants are not the same as call options. Call options often expire far before warrants do (usually less than a year, versus five or more for warrants). 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 when at the time of issuance. Also, companies often issue stock purchase rights only to existing shareholders, and they have very short lives -- generally two to four weeks.

This opportunity to participate in the upside of another security gives investors a little 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.