Valuing Exotic Options Used in Underwriter Compensation

15 Pages Posted: 4 Dec 2015

See all articles by Jacqueline L. Garner

Jacqueline L. Garner

Georgia Institute of Technology - Scheller College of Business

Beverly B. Marshall

Auburn University Harbert College of Business

Multiple version iconThere are 2 versions of this paper

Date Written: November 19, 2015

Abstract

Options, often issued to the underwriter of unit IPOs, provide an interesting application of exotic option valuation. These options, which are generally for a unit or bundle of share(s) and warrant(s), are usually redeemable so that the underwriter option on the unit represents an up and out call, a form of an exotic option. Attempts to value these warrants are hampered by the fact that the underlying security is not publicly traded prior to the issuance of the option. For valuation purposes, FINRA (formerly NASD) guidelines for underwriter compensation use a simple formula that assumes a very low implied volatility. Volatility assumptions implied by this formula are significantly lower than those levels observed for unit IPOs. We value the underwriter option using a variant of the Black-Scholes (1972) option pricing formula for up and out call options under several alternative volatility assumptions. We find that the valuation using this methodology is significantly higher than the valuation derived under INRA guidelines for valuing underwriter compensation.

Suggested Citation

Garner, Jacqueline L. and Marshall, Beverly B., Valuing Exotic Options Used in Underwriter Compensation (November 19, 2015). Journal of Applied Finance (Formerly Financial Practice and Education), Vol. 19, No. 1&2, 2009. Available at SSRN: https://ssrn.com/abstract=2693235

Jacqueline L. Garner (Contact Author)

Georgia Institute of Technology - Scheller College of Business ( email )

800 West Peachtree St.
Atlanta, GA 30308
United States

Beverly B. Marshall

Auburn University Harbert College of Business ( email )

415 Magnolia Ave.
Auburn, AL 36849
United States

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