Warrants & Convertibles Research Paper Starter

Warrants & Convertibles

(Research Starters)

This article begins with a brief history and an overview of financial investment vehicles, providing insight from the corporate as well as the investor's perspective. The reader is offered a detailed description of warrant certificates and convertible bonds, underscored with the benefits and disadvantages of each. The circumstances under which warrants or convertibles are issued by companies as a financial vehicle for investors, as opposed to common or other types of stocks or bonds is made apparent, offering valuable perspective to potential investors or issuers of these vehicles. The role of the Securities and Exchange Commission (SEC) in governance and oversight of companies' security offerings is not insubstantial and a brief high-level mention is delivered in this review.

Keywords Bear Market; Bonds; Calls; Commodities; Convertibles; EITF-00-19; Financial Accounting Standards Board; Investment Vehicles; Options; Preferred Stock; Puts; Securities and Exchange Commission; Stock Option; Volatility; Warrants

Finance: Warrants


Historical Perspective on Investing

In 1792, the first organized stock exchange was transacted in New York. Financial leaders at the time developed and agreed to a formal document of rules, regulations and fees for trading stocks and bonds; hence the launch of the stock market phenomenon. In simpler times, securities were auctioned off to the highest bidder, with the seller paying a commission on each stock sold. History holds lessons for the experienced, in terms of investments and risk, highlighted in the rapid growth in the stock market and in investors' frenetic drive to swift profits.

In addition to investors' entrepreneurial drive, interest in the common good has played a vital role in the world of stocks, bonds and investments. Soon after the United States became involved in World War II, it became paramount to enhance the efficiency and safety of existing rail transport systems. Success in the wartime endeavor hinged upon accessibility and mobility for people and resources. The railroad system at the time was woefully inadequate in terms of financing, which subsequently disadvantaged the rail's ability to meet demand.

The Interstate Commerce Act of 1887 was responsible for having created the Interstate Commerce Commission, which, under great influence from private farmers and others, prohibited the railroads from increasing rates sufficient to meet growing operating costs. Compounding the cash scarcity, the strict regulations most certainly prevented the rail from creating a positive financial margin with which to make needed capital investments in the company. Put simply, the railroads, a key element in our nation's transportation infrastructure, simply could not support growth or sustain operations without investors and their cash. The railroads ultimately were built with money from men who hoped to earn a large profit from their investment in operations and capital.

In context, today's large corporations with vast numbers of stockholders still rely on investors' interest to grow, much as the railroads offered a financial interest and a public service to the country during a critical time of conflict. The story of economics has always been influenced by enlarging corporations, in particular those representing importance to the public at large. Commodities, such as oil, wheat, corn and soybeans, are a modern day example of investments of great public import and guaranteed financial growth. The rail of yesterday, given its history, might well have been considered a primary commodity of its time.


Investment Vehicles

Companies can offer investors numerous venues in which to place their financial interests and test their financial expertise, no matter their level of experience. Corporations may finance part of their business by leveraging themselves with securities they promise to pay back, with interest, in addition to the principle. Variations on this model will be introduced later in this essay. The more debt the company incurs, naturally, the higher the organization's financial risk. A few examples of investment vehicles utilized by corporations and the government to support their financial needs include:

  • Convertibles;
  • Corporate, municipal, or treasury bonds;
  • Common Stock;
  • Commodities markets;
  • Governmental, corporate and municipal bonds;
  • Warrant certificates.


Common stock warrants offer the investor the right to buy common stock at a specific price, in the future, within a set period of time. In some cases, warrants have no expiration date; these are known as perpetual warrants. If one were looking to identify warrants on the stock listing, he or she would look for the suffix "wt." An installment warrant is an option that offers a share on credit; with the installment vehicle, the investor pays for half the share now and for the rest later. The initial installment provides the owner half a stock. The premise behind installment warrants is that they represent a long term call option (opportunity to exercise a warrant when stock price exceeds the initial investment price, resulting in a net profit) for investors who are inclined to speculate that the price of stock will increase in the long term; the longer the life before the warrant's expiration, the higher its value and the safer the investor's money. The anticipation for the investor is that the company will see increased profits in its future years, thereby growing its dividends. The owner of the warrant can watch and speculate (within the context of the expiration date) until such time as the stock and dividends look attractive enough to 'exercise' or turn the warrant over to stock ownership.

It is evident that investors should educate themselves thoroughly in the warrant vehicle and the issuing company before making this somewhat speculative investment; this education includes attention to transaction costs which will impact profit and loss calculations. "ABN AMRO's {a global banking group) Aaron Stambulich notes that while installments offer a lower-risk form of leverage than other forms of equity lending, investors still need to spend the time acquiring the knowledge to use them properly,'" (Walker, 2007).

Shorter term warrants do exist; they represent a higher risk with a robust appeal of higher returns to the investor. Both long and short-term warrants are priced lower than the common stock purchase price, thereby creating leverage and risk to the corporation, similar to bond arrangements (bonds are in essence a loan with interest). Warrants, however, do not earn interest and usually have an expiration date which can vary depending on the model employed; the key point is that warrants become worthless at expiration date or when the cost of common stock drops to a very low rate. Warrants offer no dividends or voting rights to the warrant owner. "{Warrants} are derivatives — this means they derive their value from and give investors exposure to an underlying asset, such as a share, basket of shares, index, currency or commodity, at a fraction of the underlying asset's cost (Walker, 2007).

Valuation of the Warrant

The value of the warrant is the price of the company's common stock minus the warrant's option price. As a simple example, if the price of the warrant certificate is $15 and the common stock purchase price is $20, the warrant is worth $5. In contrast, if the warrant certificate price is $20 and the stock price is $15, the warrant holds no value. It will remain so unless the stock price, in this case, enjoys favorable appreciation to bring its value above the warrant price. The higher the common stock's price, obviously, the greater the warrant's value. If the common stock is volatile, all the better for the warrant owner, as this too increases the value of the warrant.

When a warrant certificate is exercised (turned over for stock ownership) the number of shares in the company increases and the stock price does decrease overall. If there are warrants outstanding, the owners of the stock are obligated to satisfy the call (exercising) from warrant holders. The money paid to purchase the warrant at the outset goes directly to the company as does the money paid when the owner exercises the warrant to purchase common stock. The new shares generated through an exercised warrant are accounted for in financial reports as fully diluted earnings per share, which represents what the earnings per share would be if all warrants were exercised and all outstanding convertible securities, were converted to stock. In essence, the denominator (total outstanding shares) increases, so the value of earnings per share dips lower.

Warrants are sometimes attached to bonds or preferred stock as a means to reduce the interest or the dividends that have to be paid to sell the securities. These particular warrants, issued in this bundled format can be separated and traded independently of the bond or stock and are...

(The entire section is 4002 words.)