Warrants are financial instruments issued by specialized issuers (financial institutions) build on another instruments or assets (known as underlyings), for instance: an equity, an index, an equities basket, a commodity, etc.
Once an investor buys a warrant, the instrument gives the holder (the buyer) the RIGHT (but not the obligation) TO BUY OR TO SELL the underlying at a specific price (named strike price or exercise price). Having these characteristics, the warrants are similar to options.
In fact, warrants have options elements and even some could think the instruments are traded on the derivatives market. Instead, they are traded on cash market, just like shares (without using margin accounts or margin calls).
Most common warrants are issued with a certain maturity, up to 1 year, but the issuers have the possibility to choose longer maturities.
The following elements are meant to define warrants:
- Warrants exist as CALL warrants and PUT warrants:
- A call warrant gives the holder the right to buy from the warrant issuer the underlying instrument at the strike price. Call warrants holder has a bullish expectation for the underlying’s evolution.
- A put warrant gives the holder the right to sell to the warrant issuer the underlying instrument at the strike price. Put warrants holder has a bearish expectation for the underlying evolution.
- Strike price (or the exercise price) represents the level of the underlying at which the holder has the right to buy the underlying asset (in case of call warrant) or to sell the underlying asset (in case of put warrants).
- Proportion (ratio or multiplier) is the number of warrants that offer the exposure on one unit of the underlying asset (or its value). A higher proportion means a lower warrant price.
- Premium: represents the amount paid by the investor to own the right to buy or to sell the underlying asset at the strike price (the premium is the price paid for the acquisition of the warrant).
- Exercising methods. Most common exercising methods established by issuers are: European style (the investor has the right to exercise the warrant at the expiration date) and American style (the warrant may be exercised any time up to the expiry date).
What happens at expiry?
If a call warrant is exercised (the price/level of the underlying asset is higher than the strike price):
- If the warrant is cash settled, the investor receives from the issuer an amount equal to the difference between the price of the underlying and the strike set by the issuer,
- If the call warrant is physically settled, the investor has the right to buy/receive the underlying at the strike price from the issuer.
If a put warrant is exercised (the price/level of the underlying asset is lower than the strike price):
- If the warrant is cash settled, the investor will receive an amount equal to the difference between the strike level and the price of the underlying.
- If the put warrant is physically settled, the investor has the right to sell/provide to the issuer the underlying at the strike level.
WHY TRADING WARRANTS ON BVB:
- Offer the opportunity to get exposure on new underlyings, mainly local shares, but also indices and commodities without actually buying the underlyings.
- The trades are carried out in a familiar and transparent environment, as trading and settlement follow the rules of the spot market. The instruments are issued, traded and settled in local currency.
- The maximum loss is limited to the price of the warrants when they were bought by the investors. While facing this risk, the investor has a chance to receive a profit, if the difference between the prices of the underlying instruments and the prices of instruments defined by the warrants will be favorable for the investor. These gains will imply a significant value for the investor because a fraction of the value of the underlying instruments will generate a gain which will be based, to a high degree, on the variation of the prices of the underlying instruments in the market (leverage effect).
- Investors may get benefits regardless of the direction of the price/level change of the underlying. Thus, warrants allow investors to benefit from increases/decreases in the underlying price and even to hedge the decrease of the underlying’s price. However, investments in warrants are more appropriate to investors that are able to follow the market trend of the underlying asset.
- Do not require margin accounts, nor other procedures specific to derivatives markets (such as margin calls). For this reason, the maximum loss is the initial amount invested.
- The issuer acts as market maker (liquidity provider) for the warrants listed. The transparency regime with regard to the liquidity providers’ fulfillment of the monthly performance criteria also applies to warrants listed on BVB.
- The warrants listed on BVB are cash settled at expiry. This mean that the issuer will have to pay the cash amount for the intrinsic value of the warrants at the maturity. In other words, the investor will have a right to receive a cash payment equivalent to the positive difference between the strike price and the value of the underlying asset at expiry (without considering other fees or commissions).
The issuer acts as a liquidity provider.