A traditional warrant is a security issued by a company whereby the owner has the right to buy shares in that company for a fixed price (the strike price) on a pre-agreed date (the expiry date). The purchaser pays a premium for the warrant and the maximum loss is limited to this premium. Whereas, the upside is potentially unlimited and determined by the share price of the company. If the owner exercises that right, the company will issue new shares to that person. An investor is more likely to do that if the share price of the company is higher than the fixed price. Traditional warrants usually have a term of three to five years.
A covered warrant operates on the same principals as a traditional warrant with a number of important exceptions. Banks issue covered warrants and the asset does not have to be a single share. It could be a basket of equities, index, fund, currency, commodity or property market. The bank will hold assets that are in issue to “cover” the possibility that the warrant owner will exercise. Covered warrants may settled by delivery of the physical asset or in cash. In the latter case, the owner will receive the excess, if any, of the share price and the fixed price. The investor takes the credit risk of the bank as issuer rather than a company.
A traditional warrant gives the owner the right to buy or ‘call’ shares from the company and is known as a call warrant. However, a Covered Warrant may enable the owner to benefit from the price falling or trading in a range. The former is called a put warrant because the investor has the right to place or ‘put’ the shares back to the issuer. A rationale investor is only going to do this if the price at which the shares can be bought is below the fixed price that they can be sold back to the issuer for.
Hence, an investor can buy a put warrant to protect a holding of an asset against the price falling. Indeed, combining a call warrant with a put warrant can create a capital protected strategy.
Covered warrants are usually listed on an exchange, however, they are not always traded on that exchange. In common with equities, owners are putting all of that capital at risk, as the whole premium can be lost and they trade on a daily basis.
In a number of countries, covered warrants are taxable as capital gains because all of the premium can be lost, although the treatment will vary from country to country. Investors should seek their own advice in respect of taxation etc.
In addition to the credit risk of the issuer and the market risk that the warrant does not pay any return, there are a number of other risks associated with warrants (see Risks of Structured Investing).
For more information on covered warrants, please refer to the following guides from the London Stock Exchange.