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UVA-F-1430 The Pricing of Warrants
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UVA-F-1430 Oct. 3, 2008
THE PRICING OF WARRANTS Warrants are call options issued by firms, which give the holder the right to purchase shares at a fixed price from the firm. The main difference between a warrant and a standard call option is the fact that the firm is the writer of the warrant and issues the new shares, if the warrant is exercised by the holder. Exercising the warrant means that the firm receives cash equal to the exercise price and issues a new share to the holder. This means that at exercise, there are more shares outstanding. As such, the choice of exercising depends on what the stock price would be with the new shares outstanding. The way to view a warrant is as an option on the firm’s equity and not on a share of stock. In order to see how this works, we need some simple notations: Et is the value of the firm’s equity at time, t St is the common share price of the outstanding shares at time, t N is the number of old common shares outstanding prior to any exercise of the warrants Wt is the value of the warrant at time, t M is the number of warrants X is the exercise price of the warrants The choice of whether to exercise a warrant at maturity is based on the following criteria, which is shown in Equation 1. Exercise if: X
