The Risk-Shifting Effect and the Value of a Warrant

Quantitative Finance, Vol. 10, pp. 1203-1213, 2010

Posted: 25 Sep 2009 Last revised: 28 Oct 2010

See all articles by Emanuele Bajo

Emanuele Bajo

University of Bologna - Department of Economics

Massimiliano Barbi

University of Bologna - Department of Management

Date Written: April 3, 2009

Abstract

The exercise of a warrant leads to the well-known dilution phenomenon, whose effects have been extensively studied over the last four decades. In contrast, the existing literature has paid inadequate attention to the volatility spillover between stockholders and warrant holders. This “risk-shifting effect” has significant implications on warrant pricing, since any formula that assumes a constant volatility of stock returns produces a bias. In this paper we show that a CEV process with a specific elasticity parameter properly models the stochastic volatility of stock returns for a firm with warrants outstanding. Besides, we propose an approximate analytical formula, exclusively based on observable market variables, able to absorb the risk-shifting bias.

Keywords: warrant pricing, CEV models, risk shifting

JEL Classification: G10, G13, G14

Suggested Citation

Bajo, Emanuele and Barbi, Massimiliano, The Risk-Shifting Effect and the Value of a Warrant (April 3, 2009). Quantitative Finance, Vol. 10, pp. 1203-1213, 2010. Available at SSRN: https://ssrn.com/abstract=1477966

Emanuele Bajo (Contact Author)

University of Bologna - Department of Economics ( email )

Bologna
Italy

Massimiliano Barbi

University of Bologna - Department of Management ( email )

via Capo di Lucca 34
Bologna, 40126
Italy
+39 051 2098404 (Phone)
+39 051 246411 (Fax)

HOME PAGE: http://www.sites.google.com/site/massimilianobarbifinance/

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