Like a a stock option, an equity warrant offers the right to buy or sell a security at a known price for a certain period. Companies may offer equity warrants with other securities, such as stock or bonds. Warrants may trade like shares on a stock exchange.
Like an option, the warrant has an exercise price, or a price at which the investor may convert the warrants to securities. A call warrant allows an investor to purchase securities at a given price.
Say an investor owns American-style warrants that allow her to purchase the underlying security at $10, and the security price rises to $20. She can choose to sell the warrants without converting to the underlying security. The investor's broker sells the warrants at a profit by selling them on a stock exchange. If the underlying security declines to $5, the investor doesn't make money. She owns the right to purchase at a higher than market price.
By comparison, a put warrant allows the investor to sell a security at a certain price over a stated period. Say the investor owns put warrants that allow him to sell a security at $10. The security price drops to $3 in the open market.The investor makes money on the right to sell at a higher than current market price.
Structure. Most warrants trading in the U.S. markets have an American-style structure. Prices of American-style warrants rise and fall according to supply and demand. The investor may trade her warrants by calling a broker. Selling the warrant converts them to cash, according to the warrant's current market value less broker commission charges.
Conversely, European-style warrants don't trade in the stock market. Typically, a European-style warrant may be exercised at maturity, such as in five years. The European-style warrant doesn't rise and fall in value because it doesn't trade on an exchange. A third variety of warrant -- called quasi American-style -- may be exercised at certain times until the warrant's maturity date.
Features. Warrants may have special features. For example, an equity warrant called a quanto helps investors trade an international security without bearing foreign exchange risk. Each global currency, such as the U.S. dollar or British pound, trades in relationship to other currencies. Currencies rise and fall in relationship to other currencies. A quanto helps the investor take advantage of potential price appreciation in the foreign security without currency rate concerns.
Equity Financing.Warrants may be given to a funding agent, such as lender, prior to a company's initial public offering (IPO), according to "A Practical Guide to Private Equity Transactions" by Geoff Yates and Mike Hinchliffe. Providing warrants to the lender sweetens the potential upside of the transaction. If the company's shares rise in price on a stock exchange after the IPO, the lender makes money on the warrants. If the company doesn't sell public shares after giving warrants to the lender, the warrants have no value.