Currency Warrants Definition

What are currency warrants?

A currency warrant is a financial instrument used to hedge currency risk or speculate on currency fluctuations on foreign exchange (forex) markets. A currency to guaranteelike the others choice contracts, derives its value from the underlying exchange rate, where the value of a warrant increases when the underlying rises and the value of a sell warrant increases when the underlying price falls, similar to a call option.

Many long-term currency options (with expiration dates longer than one year) are called warrants.

Key points to remember

  • A currency warrant is a long-term call option that gives its holder the right to enter into a foreign exchange transaction at a given exchange rate (strike price).
  • Currency warrants are priced in the same way as short-term currency options and are used to hedge currency risk or to speculate on currency movements that will occur over a period of more than one year.
  • Warrants often allow traders to obtain greater leverage in order to amplify speculative bets.

How currency warrants work

Generally, warrants are used to manage risk if you are exposed to a certain currency and want to hedge against potential losses. The other common use of currency warrants is to speculate on the movement of exchange rates and make a profit if your view is correct. The added leverage in currency warrants allows users to be more exposed to fluctuations in exchange rates. In an uncertain macroeconomic environment, currency warrants offer those exposed to foreign currencies a longer-term solution for hedging purposes.

In currency (currencies) in the options markets, contracts with longer maturities are called warrants. In stock option markets, longer dated call and put options are referred to as LEAP.

Currency warrants are priced in the same way as shorter term currency options and entitle holders the right, but not the obligation, to exchange a set amount from one currency into another currency at a rate of specified change no later than a specified date. This is very similar to how stock options work in practice.

In some cases, currency warrants are attached to certain international bond issues so that bondholders are protected against currency depreciation to name bond cash flows.

Example of currency warrants

Imagine that you are the financial manager of a company based in the United States with large operations in Europe. Because you need to reconcile your foreign transactions in US dollars, you want to hedge your exposure to fluctuations in the EUR/USD exchange rate.

Also, since your trading in the Eurozone is expected to continue for at least several years into the future, you do not want to hedge your currency exposure using shorter-dated options. You are not interested in having to flip or re-establish your hedges frequently. So you decide to hedge using longer term EUR/USD put warrants that expire in three years.

With the Euro currently buying US$1.20, you buy a $1.00 exercise warrant expiring in three years. This way, if the Euro falls below $1.00, you will have protection or insurance that allows you to sell Euro for $1.00 even if it falls below that level, let’s say at 0.80 USD. This can be very beneficial as currency fluctuations are one of the unknowns that can be hedged. Since the option expires in several years, you don’t have to worry about renewing or reinstating your coverage until then.