What are warrants and how do they work?

Warrants are derivative financial instruments that offer investors the opportunity to buy or sell an underlying asset (such as shares, indices or commodities) at a pre-established price within a certain timeframe. These instruments, often considered a sophisticated investment option, combine flexibility and leverage, making them particularly attractive to experienced traders and institutional investors.

Unlike standard options, warrants are issued directly by a company or financial intermediary, and their use can serve both to raise capital for the issuer and to hedge specific market risks. Thanks to the implicit leverage, warrants allow investors to assume significant exposures with relatively little capital, thus amplifying potential returns but also the risk of total loss of the invested capital.

From a technical point of view, the price of a warrant is determined by variables such as the price of the underlying asset, the implied volatility, the time to maturity and the interest rate level. Advanced tools such as the Black-Scholes model are often used to estimate their theoretical value. Furthermore, warrants can be classified into call warrants (right to purchase) and put warrants (right to sell), each with different usage strategies depending on market conditions, as we will see later.

In a high finance context, warrants find application not only in speculative strategies but also as hedging or arbitrage tools. Their versatility makes them a primary choice in markets characterized by high volatility, where investors seek solutions to balance risk and return. Deepening the characteristics and operational strategies related to warrants is essential to maximize their potential.

What are warrants in finance? Let’s give a definition

warrants are financial instruments listed on the stock exchange that consist of a forward contract that grants the right to subscribe to the purchase or sale of a certain underlying financial asset at a certain price and at a set deadline.

To have a clearer picture of warrants, it is however appropriate to identify some of the terms themselves set out in the definition:

• when the purchase is subscribed to, it is called a warrant call;
• when the sale is subscribed to, it is called a warrant put;
• the underlying is identified with the name of underlying;
• the price instead is called strike price or exercise price.

It should also be remembered that the exercise of warrants involves the issuance of new shares by the company and that the purchase price of this particular financial instrument is called the premium.

How warrants work

Another important point to underline is that depending on the underlying asset, there are two very specific types of warrants:

• warrants (strictly speaking): their underlying asset is exclusively shares;
• covered warrants: their underlying asset can be shares, bonds, stock or bond indices or even baskets of securities, currencies or interest rates.

The theoretical value of a warrant is also important. In fact, it is given by the number of shares times the base value of each individual share minus the so-called exercise price.

Like any financial instrument, the value of the warrant also depends on three very specific variables which are:

• time remaining until expiry;
• price of the share to be subscribed;
• amount that must be paid to subscribe to the share.

With regard to their use, however, it should be noted that warrants are financial instruments excellent to use as insurance in the event of losses in investments of the underlying asset.

Consequently, they are used professionally not as a real form of investment, but in reality as insurance against losses of the underlying asset. Furthermore, they are structured to avoid speculation by small and medium-sized investors.

However, they too, being financial instruments, can be used to make speculative profits by managers of listed companies capable of moving large amounts of capital. Obviously, to the detriment of financial institutions.

It is also important to highlight two very significant aspects when talking about warrants.

• The first concerns the fact that their issue is successful when there are companies that have future prospects of large growth for which the shares will be issued above par, while the holder will purchase them at a pre-established price, thus benefiting from it.
• The second aspect is that the warrants are purchased by operators specialized in warrants and not by those who want control of the company. In fact, these financial instruments have their own market of quotations with a value linked to the company’s shares.

Original article published on Money.it Italy. Original title: Cosa sono i warrant e come funzionano