A Naked Warrant, also known as a “Covered Warrant”, is a financial instrument that provides the right to buy or sell a certain underlying financial asset at a certain price within a predetermined date. The difference with simple Warrants lies in the underlyings. In fact, in addition to shares, Naked Warrants can have multiple financial instruments as underlying: bonds, currencies, interest rates, stock and / or bond indices, etc.
Normally the price of a Naked Warrant is determined by the volatility of the underlying asset and its residual life mainly; but it can also be influenced by market interest rates. The concept of Naked Warrants is that they greatly amplify returns or losses as, by their very nature, they follow the trend of the underlying by taking advantage of the leverage effect. In fact, these instruments are aimed at those who want to invest only a fraction of the capital that would have required investing directly in the underlying reference of the Naked Warrant but still aim to have the same exposure.
They are heavily used as an instrument to guarantee losses in direct investments on the underlying. In fact, they allow the investor to cover any losses due to a direct investment on the activity related to the Naked Warrant (with a higher capital outlay) with a minimum capital outlay thanks to the leverage effect.
Naked Warrants can be split in an American style if they allow the holder to exercise the security at any time before maturity and, in a European style, if they can only be exercised at maturity. Finally, depending on the difference between the price of the underlying and the strike price, they can be:
• At-the-Money if the strike price is equal (approximately) to the price of the underlying;
• In-the-Money if the strike price is lower than the price of the underlying in the case of a Naked Warrant Call and higher than the price of the underlying in the case of a Naked Warrant Put;
• Out-the-Money if the strike price is higher than the price of the underlying in the case of a Naked Warrant Call and lower than the price of the underlying in the case of a Naked Warrant Put.
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