Home > Economics & Finance > Warrant Option Futures Forwards Swaps

Warrant Option Futures Forwards Swaps

Warrant

A warrant is the right — but not the obligation — to buy or sell a certain quantity of an underlying instrument at an agreed-upon price. The right to buy the underlying instrument is referred to as a call warrant; the right to sell it is known as a put warrant. In this way a warrant is very similar to an option. The difference is primarily that the length of time available to exercise a warrant is much longer than most option contracts. Most warrants have 5-10 years before they must be exercised or expire worthless. In addition, when a warrant is exercised, a new share of stock is created, whereas when an option is exercised, the owner of the option receives an existing share that is delivered by a counterparty (except in the case of employee stock options, where new shares are created and issued by the company upon exercise).

There are two types of warrants: "traditional" warrants and so-called naked warrants.

Traditional warrants are issued in conjunction with a bond (known as a warrant-linked bond), and represent the right to acquire shares in the entity issuing the bond. In other words, the writer of a traditional warrant is also the issuer of the underlying instrument. Warrants are issued in this way as a ‘sweetener’ to make the bond issue more attractive, and to reduce the interest rate that must be offered in order to sell the bond issue.

Naked warrants are issued without an accompanying bond, and like traditional warrants, are traded on the stock exchange. They are typically issued by banks and securities houses. The writer of a naked warrant need not be the issuer of the underlying instrument. A naked warrant is essentially an option with a very long time to expiry. Therefore an employee stock option is also equivalent to a warrant.

Option

An option is a contract whereby the contract buyer has a right to exercise a feature of the contract (the option) on or before a future date (the exercise date). The ‘writer’ (seller) has the obligation to honour the specified feature of the contract. Since the option gives the buyer a right and the seller an obligation, the buyer has received something of value. The amount the buyer pays the seller for the option is called the option premium.

Most often the term "options" refers to a derivative security, an option which gives the holder of the option the right to purchase or sell a security within a predefined time span in the future, for a predetermined amount. (Specific features of options on securities differ by the type of the underlying instrument involved.) However real options are another common type. A real option may be something as simple as the opportunity to buy or sell a house at a given price at some period in the future. The writer has the obligation to sell the house to the option buyer for the price agreed in the option while the option buyer does not have to purchase the house at all, so again the buyer has received something of value. Real options are an increasingly influential tool in corporate finance.

Other instruments to manage risk or to assume it include:

Futures

A futures contract is a form of forward contract, a contract to buy or sell an asset of any kind at a pre-agreed future point in time, that has been standardised for a wide range of uses. It is traded on a futures exchange. Futures may also differ from forwards in terms of margin and delivery requirements.

The standardisation usually involves specifying:

    * The amount and units of the underlying asset to be traded. This can be a fixed number of: barrels of oil; lengths of random lumber; units of weight (bushels of wheat, troy ounces of bullion); units of foreign currency; interest rate points; Equity index points; National bonds
    * The unit of currency in which the asset is quoted. Because U.S. futures exchanges have dominated the market, this is very often the US dollar (USD), even when the corresponding OTC market quotes differently (for example the Interbank market quotes in yen per USD, whereas currency futures are quoted in USD per yen).
    * The grade of the deliverable. In the case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. For example, the NYMEX Light Sweet Crude Oil contract specifies the acceptable sulfur content and API specific gravity, as well as the location where delivery must be made.
    * The delivery month.
    * The last trading date.
    * Other details such as tick size, the minimum permissible price fluctuation.

Because they vary in price as a direct function of these variables only, a futures contract is an example of a parametric contract, and is easily combined or traded as part of more complex financial derivatives deals.

Forwards

A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time. Therefore, the trade date and delivery date are separated. Beside other instruments, such as Options or Futures, it is used to control and hedge risk, for example currency exposure risk (e.g. forward contracts on USD or EUR) or commodity prices (e.g. forward contracts on oil). The forward price will usually give a good market estimation of the price in the future.

One party agrees to buy, the other to sell, for a forward price agreed in advance. In a forward transaction, no actual cash changes hands. If the transaction is collaterised, exchange of margin will take place according to an pre-agreed rule or schedule. Otherwise no asset of any kind actually changes hands, until the maturity of the contract.

The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands (on the spot date, usually next business day). The difference between the spot and the forward price is the forward premium or forward discount.

Swaps

A swap is a financial instrument–a kind of derivative security.

A swap is essentially an agreement in which counterparties (generally two) agree to exchange future cash flows arising from financial instruments. For example, in the case of a vanilla fixed-to-floating interest rate swap counterparty A agrees to pay counterparty B periodic fixed interest payments on some "notional" principal amount (say $100mm) in exchange for variable rate payments on that notional. The floating "leg" is typically periodically reset based on some reference rate such as LIBOR.

Categories: Economics & Finance
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