DEFINITION of 'Naked Warrant'

A naked warrant, also known as a covered warrant, is a derivative that allows the holder to buy or sell a security, such as a bond or share. Unlike a normal warrant, it is not attached to a newly issued bond or preferred stock. Naked warrants are issued by financial institutions and can be traded on major stock exchanges.

BREAKING DOWN 'Naked Warrant'

Companies often issue bonds and preferred stock with warrants attached to them to increase demand for an equity or debt offering — and lower their cost of capital. Warrants are securities that give the holder the right, but not the obligation, to buy a certain number of underlying securities — usually the issuer's common stock — at a certain strike price. An American style warrant enables the holder to exercise at any time before the warrant expires, while a holder of European style warrant can only exercise at the expiration date.

Naked warrants are not the same as call options, because they are issued by private parties, not an exchange, and there is a much longer time to expiry. While options usually expire in less than a year, warrants generally expire in one or two years. And while similar to share purchase rights, share purchase rights only last a few weeks. For more on the difference between warrants and call options, read Understanding Warrants and Call Options.

Normal warrants are issued with an accompanying bond (a warrant-linked bond), giving the investor holding the warrant the right to exercise it and acquire shares of the company that issued the underlying bond. The company writing the bond is typically the same company issuing the underlying bond.

Naked warrants, on the other hand, can be backed by a variety of underlying securities, including stocks, and are considered more flexible. They are sometimes called "covered" warrants because when an issuer sells a warrant to an investor, it will usually hedge (cover) its exposure by buying the underlying asset in the market. Warrant exercise prices are typically 15% above the market price at the time of issuance and usually trade at a premium to the stock price.

Pros and Cons of Warrants

Stock warrants provide investors with extra leverage, but that makes them risky investments. When the price of the underlying security rises, the percentage increase in the value of the warrant is greater than the percentage increase in the value of the underlying security. This is fine when the stock market is rising — when they are a less risky investment than options because they take longer to expire. Conversely, when the share price falls below the strike price, the shareholder can lose some or all of their money.

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