Warrants can be based on U.S. and foreign equity indices, stock baskets on industry sectors, currency exchange rates, interest rates, and other assets or indices. They are often similar to long-term option contracts (one to five years) and can be linked to major international stock indices, such as those based on stocks trading in Hong Kong, Japan, Britain, France, Europe, and so on. Warrants can be issued in the United States as Securities and Exchange Commission (SEC) registered, underwritten initial public offerings, or in private transactions.
As with many other types of option-based or option-linked structured products, the potential profitability associated with originating warrants is achieved through the ability of product originators to capture volatility spreads (i.e., the difference between the price a product can be sold for and the price at which a hedge can be purchased, in terms of price volatility), through fees associated with underwriting and selling such instruments (e.g., sales credits, management fees, and underwriting fees), and as a result of secondary trading (i.e., upstairs market making), whereby deal originators can try to leverage the learning curve advantage they obtained in structuring, valuing, and pricing a product by trading such products during periods of misvaluation (i.e., buying low and selling high).
Warrants can be issued by corporations, governments, or sovereign entities as publicly offered or privately placed transactions. They are useful to investors in capturing, for example, long-term returns, hedging, speculating, securing U.S. dollar-denominated returns from non-U.S. assets, and limiting downside price risk to cash market holdings. Warrants also provide a means for gaining investment exposure in other countries without engaging in direct cash market transactions in other countries involving commissions, costs, and currency translations that often make such transactions relatively more expensive.
An important point to emphasize is that, unlike a number of derivative instruments discussed in the news media that have unlimited risk and can sometimes produce disastrous results, the risk to a warrant investor is limited to the dollar amount or premium paid for the instrument. Such a premium, often between $3.00 and $10.00 per warrant in public deals, provides an investor with exposure to a particular market or type of asset for a specified period of time. If the investment does not work out, the investor loses the dollar premium amount paid, no more. There are no margin calls or unlimited financial risks associated with warrant investments. Just the amount invested is at risk, plus any transaction costs. Also, since the types of warrants discussed in this chapter are often listed for secondary trading on U.S. securities exchanges, they provide investors with a convenient way to access international markets during U.S. trading hours without having to conduct transactions in markets located in far away time zones (e.g., U.S. investors can trade Nikkei warrants listed in the United States during U.S. trading hours as opposed to trading in Japan during Japanese trading hours).
Warrants are popular among financial engineers because of their flexibility. Like options, warrants can be shaped to suit desired goals. Their terms, strike price, and overall pricing can be adjusted to suit investor needs and, for example, to take advantage of the magnitude and time period over which a market is expected to move, as discussed in research reports providing the impetus for launching a new product (e.g., an offering of warrants based on a weaker yen and a stronger U.S. dollar is based on a research report indicating that the yen is expected to weaken against the dollar by 25 percent over a two-year period).
This chapter dealt with warrants, optionlike instruments that can be linked to the performance of many different kinds of underlying assets in publicly underwritten offerings or privately placed OTC transactions. Chapters 68 move the discussion into the area of coupling optionlike structures, such as warrants, to debt securities to address the needs of yield- and income-oriented investors. As mentioned in Chapter 1, one way of conveying complex concepts is by linking them to concepts with which one is familiar. Since many investors are familiar with bonds, the following chapters describe how bonds can be used to preserve an investor's principal investment while providing exposure to equity markets around the world. Index- and other asset-linked notes, convertible securities, and equity-linked notes have been described as "common stocks with training wheels." They allow clients to invest conservatively yet put their toes in the water regarding speculative worldwide investments they read about but hesitate to participate in.
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