Warrants

When a securities company explains warrants to a client, or a company considers raising funds by issuing shares, warrants come up. A covered warrant issued by a third party and a share option issued by the company itself have different results on exercise, so they are treated separately.

Covered warrants issued by securities companies and others

A warrant is a security that represents the right to buy or sell a stock or other asset at a set price¹. An issuer takes the same kind of right as an option, packages it as a security, and sells it. A warrant issued on another company's shares by a third party, such as a securities company, rather than by the company whose shares are the underlying, is called a covered warrant². How options work in general is covered in Option Basics: Calls and Puts.

Consider a hypothetical example in which Y Securities issues a covered warrant (call) that represents the right to buy shares of Company Z. Company Z's share price is 2,000 yen. One unit of the warrant is the right on one share of Company Z. An investor buys 1,000 units at 100 yen per unit and pays 100,000 yen.

Profit and loss at expiry

A covered warrant is settled on its expiry date (the exercise date) by paying or receiving the difference between the strike price and the price of the underlying (the final reference price)³. No shares of Company Z change hands. If you hold a call until expiry, you receive the amount by which the final reference price exceeds the strike price. In the example above, the profit or loss for each share price of Company Z at expiry is as follows.

If the share price at expiry is 2,500 yen, you receive 500 yen per unit, or 500,000 yen for 1,000 units. After the 100,000 yen you paid, the profit is 400,000 yen. At 2,100 yen, the 100,000 yen you receive equals the price you paid, so the profit or loss is zero. At or below the 2,000-yen strike price, you receive nothing, and the whole 100,000 yen you paid is lost. However far the share price falls, your loss is limited to the price you paid. A put, which represents the right to sell, works the other way: you receive the amount by which the final reference price is below the strike price.

Figure description

Profit and loss at expiry of a call covered warrant issued by Y Securities on shares of Company Z, with a strike price of 2,000 yen and bought for 100 yen per unit. The horizontal axis is Company Z's share price at expiry, and the vertical axis is the profit or loss per unit, including the purchase price. The profit or loss for 1,000 units is 1,000 times this. At share prices of 2,000 yen or less, the profit or loss stays at −100 yen. Above 2,000 yen, it rises by 1 yen for each 1-yen rise in the share price. It is 0 at 2,100 yen and a profit of 400 yen at 2,500 yen.

Before expiry, the price of a covered warrant changes in the same way as an option premium. It depends on where the underlying price stands relative to the strike price, the time left to expiry, and how much the price moves (volatility)⁴. If you sell before expiry, your profit or loss is the difference between the warrant's price at that time and the price you paid.

The risk that the issuer cannot pay

The issuer pays the difference you receive on a covered warrant⁵. So if the issuer becomes unable to pay, you may not receive the difference even if there is one at expiry. In exchange-traded derivatives, a central counterparty becomes a party to settlement and guarantees that it is completed⁶. Payment on a covered warrant has no such guarantee and depends on the issuer's creditworthiness.

Differences from exchange-traded options

With exchange-traded options, an investor can be either the buyer or the seller of the right. A seller's loss can grow without limit, so the seller posts margin⁷. By contrast, an investor in covered warrants always opens a position by buying, so the loss is limited to the price paid⁵. How exchange-traded options on individual stocks work is covered in Single Stock Options.

Share options issued by a company

A share option is a right that, when exercised against a stock company, entitles the holder to receive shares of that company⁸. Unlike a covered warrant, it is issued by the company whose shares are the underlying, on its own shares. A security that represents share options (a share option certificate) is also called a warrant, and is a security under the Financial Instruments and Exchange Act¹⁹.

When a company issues share options, it sets their terms. The terms include the number of shares delivered on exercise, the amount paid in on exercise (the exercise price, which corresponds to the strike price of a covered warrant), and the period during which they can be exercised¹⁰. When a share option holder exercises and pays in, the holder becomes a shareholder of the company on the day of exercise¹¹. If the company issues new shares to deliver, the number of shares outstanding rises and existing shareholders' stakes are diluted¹². If, after issuing share options, the company issues new shares below the market price or splits its shares, the value of each share is diluted. The company then recalculates the exercise price downward so that share option holders are not put at a disadvantage¹³.

Where warrants trade in Japan and how they developed

In Japan, companies issued bonds with warrants (bonds with rights to subscribe for new shares) in the 1980s. The right to subscribe for shares (the warrant) and the bond often traded separately, so each could be priced on its own¹⁴. In the late 1980s, large amounts of Swiss franc covered warrants were issued, created by taking the warrants from Japanese companies' dollar bonds with warrants and repackaging them².

A bond that carries share options is called a "bond with share options"⁸. The 2001 amendment to the Commercial Code (effective April 1, 2002) created the share option system. Bonds with warrants and convertible bonds (bonds that can be exchanged for the issuing company's shares on set terms)¹⁴ were reorganized under the new provisions, for example as bonds with share options¹⁵.

In November 2007, the Osaka Securities Exchange (now Osaka Exchange) published proposed rules for listing covered warrants. The proposal described covered warrants as products that could be traded in a securities general account and that allowed a small investment per issue. To make sure issuers could pay at redemption, the proposal required issuers to have net assets of at least 20 billion yen. In its responses to public comments, the exchange revised the proposal so that, when the issuer has a guarantor, the guarantor's net assets can meet the requirement⁵. Covered warrants were listed on the Osaka Securities Exchange in September 2008¹⁶.

In a rights offering, a company raises capital by allotting share options to its shareholders free of charge, and the allotted share options are sometimes listed on the Tokyo Stock Exchange. Shareholders can then sell the share options in the market even if they do not exercise them¹².

Notes

1. Japan Exchange Group, "新株予約権証券（ワラント）" (Share option certificates (warrants)), glossary (in Japanese). ↩ ↩²

2. 吉川真裕, "カバード・ワラント―隠れた成長商品―" (Covered warrants: a hidden growth product), 証券経済研究 No. 25, Japan Securities Research Institute, May 2000 (in Japanese), abstract. ↩ ↩²

3. Japan Securities Dealers Association, "カバードワラント" (Covered warrants), glossary of self-regulatory terms (in Japanese). ↩

4. Osaka Exchange, "プレミアム" (Premium), Kitahama Investment School (in Japanese): "銘柄によって違うプレミアム" (Premiums differ by series) and "時間的価値はどのように決まるのか" (How is time value determined?). ↩

5. Osaka Securities Exchange (now Osaka Exchange), "カバードワラント上場規則等の整備について（案）" (Proposed rules for listing covered warrants), November 22, 2007 (in Japanese): the main text and the responses to public comments (the net asset requirement for issuers, and guarantors). ↩ ↩² ↩³

6. Japan Securities Clearing Corporation, "JSCCとは" (About JSCC, in Japanese), "「清算機関」の機能" (The functions of a clearing house). ↩

7. Osaka Exchange, "オプション取引とは" (What is option trading?), Kitahama Investment School (in Japanese): "オプションの買い手の特徴" (Features of the option buyer) and "オプションの売り手の特徴" (Features of the option seller). ↩

8. "会社法" (Companies Act, in Japanese), Article 2, item 21 (share options) and item 22 (bonds with share options). ↩ ↩²

9. "金融商品取引法" (Financial Instruments and Exchange Act, in Japanese; English translation: Japanese Law Translation), Article 2, paragraph 1, item 9 (share certificates and share option certificates). Covered warrants fall under item 19 of the same paragraph, as securities that represent options. ↩

10. "会社法" (Companies Act, in Japanese), Article 236, paragraph 1, items 1, 2 and 4. ↩

11. "会社法" (Companies Act, in Japanese), Article 281, paragraph 1 (payment on exercise) and Article 282, paragraph 1 (when the holder becomes a shareholder). ↩

12. Japan Exchange Group, "ライツ・オファリング" (Rights offering), glossary (in Japanese). ↩ ↩²

13. Japan Exchange Group, "新株予約権証券（ワラント）の行使価額の調整" (Adjustment of the exercise price of share option certificates (warrants)), glossary (in Japanese). ↩

14. Fuminobu Otake, Nobuyuki Oda and Toshinao Yoshiba, "転換社債の市場価格分析とリスク管理" (Market price analysis and risk management of convertible bonds), Institute for Monetary and Economic Studies, Bank of Japan, Discussion Paper No. 98-J-15, August 1998 (in Japanese): footnote 1 and "2.（1）転換社債の商品性" (Product features of convertible bonds). ↩ ↩²

15. 相沢直樹, "実務対応報告第11号『外貨建転換社債型新株予約権付社債の発行者側の会計処理に関する実務上の取扱い』の解説" (Commentary on Practical Issues Task Force No. 11, on the issuer's accounting for foreign currency convertible bonds with share options), Accounting Standards Board of Japan (in Japanese): "2 検討の経緯" (Background of the deliberations) in "Ⅰ はじめに" (Introduction), the table in "1" of "Ⅲ", and "Ⅵ 適用時期" (Effective date). ↩

16. Japan Exchange Group, "株式会社化以降" (Since demutualization), History (Osaka Exchange) (in Japanese), the September 2008 entry. ↩