A warrant is a type of derivative : a financial instrument that gets its value from an underlying commodity. In foreign exchange transactions, the underlying commodity is a currency pair.
Like options, warrants give you the right — but not the obligation — to exchange one currency for another at a pre-agreed exchange rate, known as the strike price, on or before a certain date. So, for instance, you could buy a warrant that gives you the right to exchange Dollars for Euro at a strike price of EUR/USD 1.20 until it expires on 31 December.
While warrants and options behave similarly, they differ in two fundamental respects:
Where an option is a short-term instrument that typically expires within a few months, warrants last longer. The typical warrant is valid for one to two years, and some last for as long as five years.
Any investor can buy or sell options. By contrast, you can only get a warrant from the company that issues it.
This means that:
- While options are standardised contracts regulated by the exchange on which they’re traded, one warrant’s terms can be different from another’s, because it’s the individual issuers who set them
- Options are freely traded on exchanges, but warrants are usually only available over the counter
- Because options are freely traded on exchanges, the market determines the price. This means you can find out how much options cost and track their price over time. By contrast, the issuer determines a warrant’s price
- Just as there are put options and call options, there are put warrants and call warrants. A call warrant gives you the right, but not the obligation, to buy the underlying commodity from the issuer, while a put warrant gives you the right, but not the obligation, to sell the underlying commodity back to the issuer. Warrants where the underlying commodity is a currency pair are usually call options.
- Issuers sometimes link warrants to bonds, shares, or other types of equity. The warrant protects bondholders or shareholders from currency fluctuations that could impact their bonds’ or shares’ value.
- A warrant that isn’t linked to a bond, share, or other type of equity is known as a covered warrant. Ironically, another name for a covered warrant is ‘naked warrant’.
Want to know more?
- Unlike conventional warrants, covered warrants can be traded on stock exchanges. This document issued by the London Stock Exchange explains how covered warrants work in detail, as well as the risks involved.
- Because they can be traded on stock exchanges, covered warrants are sometimes used by speculators. This video outlines the risks and runs through a number of effective trading strategies.
‘If you have regular exposure to foreign currency fluctuations, warrants can be a more convenient way to hedge your risk than options. Because warrants expire after years, not months, you can retain a long-term hedging position without having to roll it over every so often.
Needless to say, warrants aren’t suitable for everyone and you should make sure you understand the risks before you trade them.’