Warrants: The Right to Buy Stock at a Set Price
A warrant is a well-known derivative instrument which generally gives the warrant-holder a right to purchase and own underlying stock at a certain predetermined strike price. A warrant-holder can buy the issuing company's stock at an attractive price at a later date. It is a discount to the company's stock, and companies issue these along with a debt or preferred stock issue. It makes the yield attractive for potential debt investors.
A warrant has an inherent conversion ratio fixed at the time of issue. The conversion ratio is the total shares issued to the warrant-holder when he exercises the warrant. An American warrant can be used at any moment on or before the expiration date, while European warrants can only be used on the expiration date. Warrants that give the right to buy a security are known as call warrants; those that give the right to sell a security are known as put warrants.
Types of warrants: a detachable warrant may be separated from the debt or preferred stock along with which it was issued, and can be sold on its own. A wedded warrant can't be separated from the debt or preferred stock; the holder has to surrender the attached instrument too, if he wants to use the warrant. A naked warrant is issued without a debt or preferred equity instrument. A covered warrant is usually given by a financial organization that already owns the underlying shares, so no new shares need to be issued upon exercise.
The advantages: high transparency, since the performance of a warrant can be traced by observing the movement of the underlying securities; benefit to speculators and hedgers; low cost, since warrants are generally priced lower than the shares, making them eligible for small capitalists; high returns, since they are mostly held with a long-term investing perspective; and transferability, since warrants are easily movable by transfer of possession, with no registration formalities.
The disadvantages: high risk, since the outcome depends on the stock it is aligned to, which is volatile to market fluctuations; the value may fall to zero, so the full investment value can be lost; high loss possibilities, since the holder can either earn a substantial profit or take a significant loss; limited control over the organization, since warrant holders do not have the same rights as shareholders, for example they cannot participate in annual general meetings; and a warrant lapses if it is not redeemed on or before the expiration date.