Call Warrant: Benefits, Criticism, Example

What Is a Call Warrant?

A call warrant is a financial instrument that gives the holder the right to buy the underlying stock shares at a specific price on or before a specified date. Call warrants are often included in a new equity or debt offering from a company. A call warrant's purpose is to provide an added inducement to invest in the stock or bond issue. Call warrants are usually detachable from the accompanying stock or bond certificate and trade separately on major stock exchanges. A call warrant is sometimes simply referred to as a warrant.

How Call Warrants Work

The price at which the warrant holder can buy the underlying stock is called the exercise price or strike price. This strike price is often set "out-of-the-money," i.e., it is fixed at a certain percentage above the underlying stock's current trading price.

The inclusion of a call warrant feature may enable the company to lower the cost of its debt. The risk of potential equity dilution if all the warrants are exercised is more than offset by the additional equity capital available to the company at no extra cost. That is an especially important consideration during periods of severe stress in financial markets.

While a call warrant has a strike price and expiration date like an option, there are some fundamental differences between them. Warrants are issued by companies, while exchange-traded options are listed by an exchange. Warrants also have much more time until expiration than most options.

Benefits of Call Warrants

Like call options, call warrants enable speculators and investors to make enormous profits if the company's stock price increases. Call warrants also allow firms facing financial difficulties to raise funds without taking on additional debt. That is a big benefit because the companies might otherwise have to issue high-yield bonds to fund operations due to their distress. High interest rates could eventually force them into bankruptcy.

In some cases, firms like financial institutions simply cannot continue operations with the low credit ratings that excessive debts inevitably bring. That leaves them with few options except to issue call warrants or new shares when they desperately need more cash.

Call warrants are particularly useful for large investors. They often cannot make meaningful investments in call options because the options market is too small for them. Furthermore, it is precisely the distressed companies that want to issue call warrants that are most appealing to value investors.

Criticism of Call Warrants

Naturally, most of the criticisms of call options also apply to call warrants. Some investors see them as too risky and overly speculative. If an investor buys call warrants and the stock fails to go up in price, significant losses may occur. Since warrants generally have more time to expiration than options, this danger from time decay is lower, but it is still a major issue.

For growth investors, there are other significant issues with call warrants. Firstly, the rapidly growing companies that growth investors favor are much less likely to issue call warrants. Many successful growth companies actually have substantial cash reserves and do not need to issue call warrants. Secondly, call warrants tend to be fairly illiquid, which makes it harder for growth investors to cut losses.

Real World Example

Warren Buffett provided one of the most famous and successful examples of investing in call warrants. In 2011, Buffett's Berkshire Hathaway made a $5 billion investment in preferred shares of Bank of America that included call warrants. The call warrants gave Berkshire the right to buy 700 million shares of Bank of America for $7.14 each at any point in the next ten years. Bank of America was still striving to recover from the 2008 financial crisis in 2011, so the ability to buy at $7.14 was not particularly valuable then.

However, shares of Bank of America rose to $24.32 per share by 2017. At that point, Buffett decided to exercise Berkshire's call warrants. The cost was just $7.14 per share for 700 million shares, so the total purchase price was about $5 billion. Since the 700 million shares were then worth $24.32 each, Berkshire's new purchase was worth over $17 billion, for a total profit of more than $12 billion.