A warrant is similar in many ways to a call option: it gives the holder the right but not the obligation to buy the underlying asset (typically a company share) at a specified price on a specified date. There are two forms of warrant of interest to the private investor: the traditional corporate warrant, and the covered warrant.
A corporate (equity) warrant is issued by a company. It offers the holder the right to buy the underlying equity (usually ordinary shares) at a predetermined price on specified dates, or at any time up to the end of a predetermined time period. A warrant differs from an option in that options usually have a life of less than 1 year. You will see the market price for a warrant quoted along with the share price in financial pages for those companies that have corporate warrants in issue. Once the conversion date arrives, warrant holders are entitled to subscribe for ordinary shares on the terms specified.
Just as with an option, a warrant becomes valuable once the market price of the ordinary shares rises above the exercise price of the warrant. There is the same gearing effect: warrant prices tend to be far more volatile than the prices of the ordinary shares, making them a riskier but potentially more rewarding investment.
A covered warrant is an option issued by a third party, usually a finance house. The warrants can be issued on any number of underlying securities, including single equities, a basket of shares, or even a market index. The issuer of the warrant hedges their position using derivatives, such as traded options, and underlying shares; hence the term covered. Whereas corporate warrants are essentially a form of call option, covered warrants are also available as put options.
Covered warrants are listed on the London Stock Exchange and can be readily traded. The transaction costs are relatively low and they are designed to be a retail product (of interest to private investors as opposed to institutional investors). Their pricing is easier to understand than some other forms of derivative, although these are still quite complex. Covered warrants tend to be compared to spread bets, which have some similarities from an investor’s point of view. It is argued that covered warrants are more transparent (you can understand the pricing better), but spreads have the advantage of being free of capital gains tax. Since profits are essentially short term and capital as opposed to income, the tax treatment of covered warrants is a disadvantage.
If you are interested in looking into covered warrants in more detail (and before contemplating any investment), a helpful on-line learning resource is available from the London Stock Exchange (LSE). To access the tutorial on covered warrants you need to register, but registration is free and takes only a few minutes.
A brief explanation of spread betting is the subject of our next page.
|9 October, 2008 © 2008 K.R.Wade and Co Ltd|