This report will encompass brief explanation of common derivatives namely, options and warrants.
What are Options?
A contract which enables the investor to buy or sell a particular financial instrument is known as an option ( Rao, 2003, p. 676). The underlying financial product in equity option is stocks. These contracts have expiry dates; hence an investor can exercise option before its expiration. The options can be exercised at a specific price which is known as striking price or exercise price (Rao, 2003, p. 676). Essentially options are of two types, call option and put option.
Call option: It is an option which allows the option holder to buy or call a specific number of shares at a specific price, within an already specified time period (Rao, 2003, p. 677). For instance, 3 months ago, an investor purchased a 6-months call-option on 500 shares of Hewlett Packard at the strike price of $40 per share. If the current market price of the stock is $50, the investor has a choice to exercise the option and purchase 500 shares at $40 instead of $50. This implies that an investor would want to buy a call option if he expects the market price to rise above the exercise price (Rao, 2003, p. 677)
Put option: It is an option which allows the option holder to sell or put a specific number of shares at a specific price, within an already specified time period (Rao, 2003, p. 678). This is exactly vice versa to call option; therefore an investor would purchase a put option if he expects the market price of the stock to get lower than the exercise price.
Risk and Returns associated with options
A lot of investors employ options as tools to mitigate their risk in investment, in other words, they insure their investment in stock against any fall in market price (Rao, 2003, p. 679). For e.g. an investor holding a put option has saved himself from even a 100 percent decline in the market price of shares of ABC Company, and he can still sell the stocks at the specified strike price. This practice is also known as hedging, as the name suggests; the investors hedge their risk in the respective investment.
However, despite its ability to hedge risks, it should never be neglected that like any other investment it has no guarantee of 100 percent return or security. An investor can risk investing huge sum in the shape of premium price of an option. For e.g. if an investors buys a call option and the price of the stock falls below the exercise price, he gets exposed to potential losses. But it is evident that the losses will be relatively lower than what actual stock holders will bear. Hence it can be verifiably be said that options are great instruments for mitigating risk, provided that an investor is able to predict the future stock price movement with much precision and exercise options at the right time in order to make profit.
What are warrants?
A warrant is a security issued by a company which grants the warrant holder, a right to purchase a specific number of common shares at a specified price, before the warrant expires (Mathur, 2000, p. 436). Investors exercise their warrants when they buy shares directly (trading between the broker and the investor), or trade over the counter. Warrant holders have no claim on dividends and no voting rights. Warrants also are issued with bonds and preferred stocks. Moreover, warrants with bonds can be traded separately in the market as well (Mathur, 2000, p. 437).
Characteristics of Warrants
There are three main characteristics of warrants which are as follows,
1. Expiration date: Investors can exercise their option of converting the warrants into shares any time before the warrant expires (Mathur, 2000, p. 437). Generally the life of a warrant is 5-10 years. Hence, during this time, the warrant holder can easily exercise the warrant as per the need and opportunity.
2. Premium price: The price that warrant holders agree to pay for buying shares in future, is known as exercise or premium price Mathur, 2000, p. 437). This price is generally 10% to 30% above the prevailing market price of the shares. For e.g. if the market price of Microsoft Corporation is $80, then the warrant issued can be set at $96 (20% above the market price). Therefore, if the stock price rises, the warrant holder can either exercise the warrant to buy shares or sell the warrant in market. However, if the current market price of the stock becomes equal to or less than the exercise price, the value of the warrant becomes zero (Mathur, 2000, p. 438).
3. Exposure to investor: Warrants are always issued by with provisions which clearly specify the number of shares that can be bought with a single warrant (Mathur, 2000, p. 438).