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B. Venkatesh

SEBI recently put out a concept paper that discusses the introduction of new instruments in the capital market. One such instrument is the third party warrant. What is this instrument?

Third-party warrant is a derivative issued by the holders of the underlying instrument. Suppose Tata Motors issues one lakh warrants which gives the holder the right to convert each warrant into one share at Rs 500. This warrant is company-issued. Suppose, a mutual fund that holds 10,000 shares of Tata Motors sells warrants against those shares, also exercisable at Rs 500 per share. These are called third-party warrants.

But why have third-party warrants? The primary advantage is that the instrument helps in the price discovery process. In the above case, the mutual fund selling a one-year warrant exercisable at Rs 500 sends a signal to other investors that the stock may trade at Rs 500 levels in one year. If volumes in such warrants are high, the price discovery process will be that much better; for it would mean that many investors believe that the stock will trade at that level in one year.

Third-party warrants are essentially long-term call options. The seller of the warrants does a covered call-write. That is, the seller will hold the stock and sell warrants against them. If the stock does not cross Rs 500, the buyer will not exercise the warrant. The seller will, therefore, keep the warrant premium.

The buyers of the warrants will be those taking a long-term view on the stock. If the stock does, indeed, move past Rs 500, the buyer will exercise the warrant, buy the stock and hold it. Or he can sell the same in the spot market and pocket the difference. An important point is that third-party warrants will be delivery based unlike the options market, which is at present cash-settled.

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