The Risk-Shifting Effect and the Value of a Warrant
23 Pages Posted: 27 Feb 2007 Last revised: 28 Sep 2009
Date Written: January 7, 2008
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, as we document in this paper. We prove that a CEV process with a specific elasticity parameter properly models the stochastic volatility of stock returns for a firm with warrants outstanding. Besides, contrarily to most of the existing warrant pricing approaches, we propose a closed-form 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: Suggested Citation