Derivatives: introduction to covered warrants: what is a covered warrant?
A Covered Warrant, is similar to a Warrant (see STSM114010) or an Option (see STSM112010) which gives the holder the right, but not the obligation, to purchase a specified quantity of an underlying security at a specified ‘strike’ price per share i.e. the covered warrant exercise price, within a specified future date.
But, unlike warrants which are issued by a company giving the warrant holder only a right to purchase new shares in that company, covered warrants are issued by financial institutions covering a wide range of securities which can be bought or sold.
A warrant is said to be ‘covered’ if the warrant issuer places the underlying securities of the warrant in a trust or other custodial arrangement. In other words, at the time when the warrants are issued, the issuer is the beneficial owner of a sufficient number of underlying shares to ‘cover’ any subsequent exercise of the warrant. The writer of the warrant may have to purchase the underlying securities to ‘hedge’ against expectancy of the warrant being exercised.
The price paid for the issue of a covered warrant is called the premium. The holder of a covered warrant typically pays a premium as obtaining a right to buy or sell the underlying asset covered by the warrant has market value.
As covered warrants are listed on the London Stock Exchange, the rights to a covered warrant can be secondary or onward traded before warrant expiry at a price that changes according to the price of the underlying share.
All covered warrants specify an end date and time for which the rights under the warrant can be taken up, after which the warrant will lapse.
Being exchange regulated, covered warrants normally have standardised contract specifications that outline:
- Exactly what the underlying asset is;
- Where and how the underlying asset is to be delivered upon warrant exercise (if the underlying asset is capable of being delivered);
- How much money the warrant holder will gain or lose as the open market price of the underlying asset changes; and
- What each party to the warrant is obliged to do when the warrant is exercised.
Covered warrants have a standardised life span of three, six, nine, twelve or eighteen months but, unlike a traded option, do not stipulate a quantity minimum contract size of the underlying asset.
A holder of a covered warrant can:
- Exercise the warrant anytime prior to its expiry; or
- Allow the warrant to lapse on expiry; or
- Sell the rights to the warrant anytime prior to its expiry.
Typically, a covered warrant does not require the underlying shares to be delivered on exercise of the warrant. Covered warrants that are exercised are usually settled in cash and this includes instances where the terms of the covered warrant permit delivery of the underlying security upon exercise, but the issuer of the warrant retains the right to settle in cash.
Occasionally, however, the holder of the covered warrant may have the discretion in determining settlement upon exercise of the warrant by a delivery of shares or cash. In this situation, a stamp tax implication can arise (see STSM116020)