DEFINITION of Currency Warrants
A currency warrant is a financial instrument used to hedge currency risk or speculate on currency fluctuations in foreign exchange markets. Many long-term currency calls and puts (with expiration dates in excess of a year) are referred to as warrants. A currency warrant, like other options contracts, derives its value from the underlying exchange rate, where a call warrant's value goes up as the underlying rises and a put warrant's value goes up when the underlying price falls.
Currency warrants are priced the same way as shorter-term currency options and allows holders the right, but not the obligation, to exchange a set amount of one currency into another currency at a specified exchange rate on or before a specified date.
In some cases, currency warrants are attached to certain international debt issues so that bondholders are protected against a depreciation of the currency denominating the bond's cash flows.
BREAKING DOWN Currency Warrants
Typically, warrants are used to manage risk if you have exposure to a certain currency and wish to hedge against potential losses. The other common use of currency warrants is to speculate on the movement of exchange rates and earn a profit if your view is correct. The added leverage in currency warrants allows users to gain more exposure to exchange rate movements.
In currency (forex) options markets, longer maturity calls and puts are referred to as warrants.
Example of Currency Warrants
Imagine that you are the financial officer for a U.S. based firm with large operations in Europe. Because you must reconcile your foreign transactions in U.S. dollars, you wish to hedge your exposure to fluctuations in the EUR/USD exchange rate. Furthermore, since your Eurozone operations are projected to continue for several years into the future at least, you do not want to hedge your forex exposure using shorter term options and then having to roll over or re-establish your hedges on a frequent basis. You therefore decide to hedge using longer term EUR/USD put warrants that expire in three years time.
With the Euro currently buying USD $1.20, you purchase a $1.00 strike put warrant expiring in three years. This way, if the euro currency falls below USD $1.00, you will have insurance in place that you can sell euros for $1.00 even if it falls below that level, say to USD $0.80. Because the option expires in several years, you do not need to worry about rolling over or re-establishing your hedge until that time.