Covered warrants are securitised options issued by a third party (i.e. not the issuer of the underlying), usually a bank. The issuer hedges the risk of paying if they expire in the money. They differ from most other warrants in being issued by a third party, rather than the issuer of the underlying.
Although they are legally different from traded options (being securities rather than contracts), covered warrants are much the same from an investor's point of view, except:
- Settlement at expiry is not guaranteed by the exchange, but by a guarantor; usually the issuer. This is not usually a major concern as covered options are a high risk instrument and the issuers are major banks — the risk of failure to settle is, in this context, comparatively negligible.
- They are traded on the same exchanges as shares and bonds, and can be traded through the same brokers, so are more accessible to private investors. In the UK, private investors trading in these (and other) high risk investments are required to sign a risk warning and confirm they understand the risks involved first.
- They are often illiquid and market maker spreads can very wide on deeply out of the money warrants. The issuer is usually the only market maker (when the trading system requires one).
The range of underlying securities for covered warrants is fairly broad and includes shares, commodities, indices and currencies. Terms are call or put European with automatic cash settlement at expiry.
Investing in covered warrants
Covered warrants may be used speculatively or to hedge a portfolio, both in the same was as traded options. Because they are aimed at retail investors it is not usual for covered warrants to be used to exploit arbitrage opportunities.
Apart from offering an accessible way to hedge equities, another reasonable (in risk terms) use for covered warrants is as a high risk portion of a larger portfolio. Rather than having a portfolio entirely invested in moderate risk investments (e.g. a well diversified equities portfolio), it is quite reasonable to split a portfolio between safe investments (usually most of it) with a small high risk portion within it.
This also has the advantage of making downside risk more certain: for example a closet tracker might well lose half its value in a crash, however a portfolio that is 95% in gilts and 5% in covered warrants (or options) will not lose more than 5% of its value in the period till the warrants expire. This is also an advantage of covered warrants and options over other ways of gearing exposure such as margin trading.