What is the difference between a warrant and an option on a stock?
Apparently both represent the same right to receive a share of stock at the strike.
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1$\begingroup$ Is the difference strictly legal/accounting, or depends on jurisdiction? Or, there is some difference in practice, e.g. warrants are issued to service providers of privately held companies in some scenarios where options aren't used? $\endgroup$ – Jared Aug 20 '20 at 17:26
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$\begingroup$ No, warrants are issued by the firm whose stock underlies the warrant. In more than 99% of cases, warrants are a way to issue new shares and use those to pay back a bond issue. $\endgroup$ – kurtosis Aug 21 '20 at 15:02
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As someone who has traded options and warrants, I will say that they can be similar... however, there are a number of differences to keep in mind.
Options
An option on a stock is the "right but not the obligation"$^*$ to buy or sell a number of shares at a strike price. You may choose not to exercise the option and buy or sell the shares. The right to buy Tesla stock at \$1/share is valuable whereas the right to sell the stock at \$1/share is a right you would not exercise (unless you wanted to give away money). The shares come from you if you sell or from another shareholder if you buy.
Sometimes, options are just financial: you get the difference between the strike price and the current stock price in cash.
Options may be traded on an exchange in which case they are usually
- standardized (schedule of expiration dates, standard number of shares, regular spacing of strike prices),
- margined (traders must post money to back the trade),
- marked to market (profits/losses realized daily),
- positions are netted (buy then sell of a position is not two positions but a zero position), and
- trades are centrally cleared (the clearinghouse, a well-capitalized intermediary, steps in and becomes the party on the other side of every trade).
These features greatly reduce the exposure to your counterparty risk: the risk that the person on the other side of the trade will not make good on their promise by going bankrupt or just not paying. However, exchange-traded options tend to not have distant expiry dates; many expire at the end of the quarter.
Options which are traded OTC (often, over the phone or email/Bloomberg) can have any number of shares underlying the option, any strike price, and any expiration date.
Both exchange-traded and OTC options may be American (exercisable at any time), European (exercisable only at expiry), or even Bermudan (exercisable on select dates and at expiry).
($^*$ This phrase -- "the right but not the obligation" -- is a bit of a shibboleth and you will hear it often when people define options.)
Warrants
A warrant is like an option, except that it is issued by the firm whose stock underlies the warrant. Yes, you will see "warrants" issued by investment banks but those are not actually warrants.
Almost all warrants are call warrants. A call warrant allows the holder to exercise and force the firm to issue (new) shares to the warrant holder. Thus call warrants can be dilutive in that more shares have a claim on the same dividend pool and voting rights.
Put warrants are rare but allow holders to force the issuing firm to buy back shares at the strike price if the stock price falls below the strike price. For an example of such a buyback, read here about General Electric doing so in the UK. You can get an idea how rare that is by the article referring to the approach as "novel."
Often, call warrants are issued attached to bonds. In those cases, the warrants expire when the bonds mature; the warrant may only be exercised at expiry; and, the face value of the bond is equal to the warrant shares times the strike price. The idea is that if the stock does well, the firm will issue shares which repay the bond issue. For a growing firm with a rising stock price, issuing more shares instead of spending cash to retire bonds may be sensible.
Warrants may be traded on an exchange, however they are rarely liquid and are mostly traded OTC. Furthermore, exchange-traded warrants are not standardized, and have no margining, marking-to-market, or central clearing.
Convertible Bonds
If we are going to talk about warrants, we need to talk about convertible bonds. A convertible bond is effectively a bond with an attached warrant -- except you cannot detach the warrant and trade it separately. Some terminology is also different: conversion price instead or exercise price, maturity date instead of expiry date, conversion ratio instead of shares per warrant.
Most convertible bond pricers even do the pricing as a bond plus a warrant. Like warrants, convertibles are dilutive, may only be exercised at maturity, and are mostly traded OTC.
Credit Issues
Finally, we should say something about credit issues. The types of firms with options listed on their stock tend to be large- to mid-capitalization firms. That means they tend to have good credit.
The types of firms which issue warrants or convertibles are firms which are not flush with cash and who are hoping their stock will grow. These firms may be startups, in high-growth industries, or be firms with worse credit. That leads to a skew in the types of firms which have listed options versus the firms which have issued warrants.
There is one historical exception to this: Japan encouraged the issuance of warrants and convertible bonds after the real estate bubble burst in the 1990s. The Ministry of Finance had forbidden equity issuance because it would dilute shareholders and frighten away investors. However, they allowed warrants and convertible bonds to be issued (because... investors wouldn't figure out that those were dilutive?).
That led to many firms -- and even blue-chip companies like Sony and Toyota Motor -- issuing convertible bonds and warrants. Furthermore, the firms wanted these to expire in the money so they could raise more equity capital. Therefore, the warrants and convertibles often had strike prices which could reset downward at certain times.
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in addition to the answer above:
If the option is settled on an exchange, the terms will be standardised and a secondary market will exist making it a liquid instrument (with dedicated counterparties offering to match each side of the trade). A warrant will be more thinly traded and will trade over the counter (OTC), and will have terms that are specific to that warrant when it was issued. Warrants are usually longer dated than options and have likely been issued as a sweetener on a low yielding bond or equity.
A warrant is issued by the company whose equity is reflected in the warrant, whereas an option can be issued (written) by anyone even if they do not own the stock to sell (although this can be very risky).
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$\begingroup$ Also, in modeling warrant value, it is not uncommon to assume that exercise will dilute equity in the underlying, making it somewhat less valuable. $\endgroup$ – Brian B Aug 20 '20 at 18:37
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$\begingroup$ Though there is an argument as to whether dilution is already priced into the stock (and hence only relevant for dividing dividends and voting). $\endgroup$ – kurtosis Aug 20 '20 at 23:00
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2$\begingroup$ @kurtosis while the potential dilution should certainly be priced into the stock, it would logically be done on an expectations basis. Warrants with low exercise probability would similarly not be affecting priced-in dilution much,. Hence I would take issue with someone saying that, for that "priced-in" reason, dilution does not technically need to be considered as one evaluates the expected value of warrant exercise/expiration. (Whether the effect is of meaningful size is really the relevant issue) $\endgroup$ – Brian B Aug 21 '20 at 18:35
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1$\begingroup$ @BrianB Well, the usual argument is "you issued a bond which increased liabilities, so that is already priced in and the warrant just means you can trade paying off the liability for spreading future dividends and voting thinner." I can see it both ways -- and I'm not sure if anyone has studied if dilution is fully or partially priced in. $\endgroup$ – kurtosis Aug 21 '20 at 18:37
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$\begingroup$ @kurtosis ah yes, I see that working within some kind of a Merton Model framework. (And I am not aware of studies either -- really this comes up too seldom for me to be optimistic they exist) $\endgroup$ – Brian B Aug 21 '20 at 18:43
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They are both fairly similiar to each other, in that they both give the owner the right to buy the underlying asset, at a certain price, at a certain period in the future.
The difference between the two is that individual investors can issue options, yet warrants can only be issued by the company to individual investors.
They are both complicated financial instruments and are very similar, the only difference being who issues the contract.
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1$\begingroup$ There are other differences as well. Exchange traded warrants can be puts or calls. They can be American or European exercise. They tend to have much longer expirations than options and when exercised, they are dilutive because the investor receives newly issued stock whereas an exercised option involves the purchase/sale of existing stock. $\endgroup$ – Bob Baerker Aug 20 '20 at 18:07
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$\begingroup$ How do you get newly-issued shares when exercising a put warrant? $\endgroup$ – kurtosis Aug 20 '20 at 21:09
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$\begingroup$ Answered my own question: turns out it has been done once. $\endgroup$ – kurtosis Aug 20 '20 at 23:01
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$\begingroup$ When the warrants are exercised, the company sells shares to the investor. That raises capital for the company. $\endgroup$ – Bob Baerker Aug 21 '20 at 18:08
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2$\begingroup$ @BobBaerker No, that is for a call warrant. Put warrants are very rare and are used to do buybacks. Call warrants are also never American because the whole reason for a call warrant is to cashflow-match a related bond repayment. I think what you have seen trading on-exchange as warrants are "covered warrants" often created by banks -- which are not actually warrants. (I recall they were just called that to cash in on heavy interest in warrants in the past.) $\endgroup$ – kurtosis Aug 21 '20 at 20:08
