Definition of Finance Warrants
Warrants are financial instruments that enable the holder to exercise the right of purchase or sale of a security for a contractually stated price. A warrant may either be attached to a security, such as a stock or bond, during a sale, or it may be sold independently. The primary features of a warrant are its stipulated price and expiration date.
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Warrant
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A warrant is a security, in the form of a contract, that guarantees the holder the ability to buy a security from an issuing company at a specified price. Specifically, a warrant is a non-certificated equity security. A non-certificated security refers to one that is purely electronic, like a stock option. A company may offer a warrant as a way of creating a financial incentive to potential buyers to purchase a security at a price below the market value.
Warrants and Options
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Both a warrant and an option are contractual securities that allow a person to buy at a predetermined price within a specified period. An option is slightly different from a warrant in that its value is derived from the underlying value of the asset available for purchase or its sale value. In either situation, the originator of the security benefits from lower interest or dividend payments. During sale, options or warrants may also be offered as an attachment to the issuance or a stock or bond as a premium.
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Features
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The expiration date of a warrant is a feature of particular note, because it alerts the holder of the last date of possible purchase or sale for the contractually stated price. Depending upon the underlying value of the asset, the warrant holder may hold on to the warrant for as long as possible to ensure that the security appreciates as greatly as possible before purchase. Because the purchase price is already guaranteed by the warrant, the larger the discrepancy between the warrant's contractually stated price and the market price, the greater the value of the warrant.
Warrants may include a variety of exclusions or restrictions to purchase. Other parameters of the warrant include its leverage, or gearing value, which determines the level of risk exposure the warrant exerciser has to the securities versus purchase as a non-warrant exerciser, and finally, its premium, which is the price discrepancy between the market value and the warrant price should the market value of the security drop below the warrant price.
Value of Warrants
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To calculate the value of a warrant, the holder must take into account the price paid for the warrant, security payments, required rate of return and face value of the security (also known as the market price). A warrant will hold value only if the contractually stated price is below the market's price for the security. The rate of return is the ratio of the investment that is gained or lost--calculated as the discrepancy between the purchase price of the security and the warrant's price--relative to the total amount invested, which is the warrant's purchase price in this scenario.
Types
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An equity warrant grants the holder the ability to buy or sell a security at a specified price. An index and basket warrant follow a market index and perform accordingly. Wedding and detachable warrants are sold with a security and must be detached before exercising the rights of the warrant. Finally, a naked warrant is sold without attachment to any type of security.
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