The risk-shifting effect and the value of a warrant

Emanuele Bajo and Massimiliano Barbi

Quantitative Finance, 2010, vol. 10, issue 10, 1203-1213

Abstract: The exercise of a warrant leads to the well-known dilution phenomenon, the effects of which 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 for 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. In addition, we propose an approximate analytical formula, exclusively based on observable market variables, that is able to absorb the risk-shifting bias.

Keywords: Corporate finance; Applied finance; Corporate risk management; Corporate valuation (search for similar items in EconPapers)
Date: 2010
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Citations: View citations in EconPapers (7)

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DOI: 10.1080/14697680902953841

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