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 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 and
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 notation:

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:

Exercise if

ET + M ⋅X
X < , (1.)
N+ M

ET + M ⋅X
where is the per share price if all the warrants are exercised. If the stock
N+ M
price after all the warrants are exercised is greater than the warrant’s exercise price, all
holders of the warrants will exercise. Hence the payoff of a warrant at maturity is

 E + M ⋅X 
Max T − X ,0  (2.)
 N+ M 

This is quite different than the payoff of a regular call option in that the payoff depends
on the number of warrants outstanding. For regular call options the number of call
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options outstanding does not affect the payoff since in that case the exercise of the option
does not change the number of shares outstanding.

It turns out to be very useful to rearrange equation 2.

 E + M ⋅X 
Max T − X ,0 
 N+ M 

 E + M ⋅X N + M 
Max T − ⋅X ,0 
 N+ M N+ M 

 E + M ⋅X − N ⋅X − M ⋅X 
Max T ,0 
 N+ M 

 E − N ⋅X 
Max T ,0 
 N+ M 

N E 
Max T − X ,0 
N+ M N 

This means that the payoff on the warrant depends on the Value of Equity at maturity and
the value of the warrant is the usual value of a call option with an exercise price of X, a
E
time to maturity of T, volatility, risk-free rate and an underlying asset of T . The
N
E E
underlying asset value is the value of T today or 0 . Hence the value of the warrant
N N
today must depend on the value of call option adjusted for the dilution effects of the
warrants, or

 E0 
 UAV = N 
 Maturity = T 
N  
Warrant Value = ⋅Call  R = 
N+ M  f

Volatility = σ 

Exercise = X  

Usually, if I ask the question what is the value of equity the response is that it is current
common share price times the number of shares outstanding. However, the real
definition of the value of equity is

Value of Asset-Value of Liabilities (Debt) = Value of Equity

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If there are warrants outstanding, these along with the common stock represent a claim on
the value of the equity of the firm. As such, the value of equity at time 0, E0, is

E0 = # of common shares x Common stock price + # of warrants x warrant price

or

E0 = N ⋅S 0 + M ⋅W0 .

The underlying asset value, UAV, is

E0 N ⋅S 0 + M ⋅W0 M
UAV = = = S0 + ⋅W0
N N N

and the value of a warrant is

 UAV = S 0 + MN ⋅W0 
 Maturity = 
 T 
N  
W0 = ⋅Call  Exercise ⋅Pr ice = X 
N+ M Risk − free ⋅rate 
= Rf
 

 volatility = σ 


What is strange about this is that the value of the warrant depends on the value of the
warrant! Consider the following example. A firm has issued 1 million warrants, with an
exercise price of $20 and a maturity of 2 years. There are 22 million common shares
outstanding with a current price of $15 per share. The continuously compounded 2 year
risk-free rate is 4% and the volatility estimate of the stock is .35. The value of the
warrants would be
 UAV = 15 + 221 ⋅W0 
Maturity = 
 2 years 
22  
W0 = ⋅Call ( Black − Scholes ) X = 20 ⋅
22 + 1  R = 4 .0 % 
 f


 σ = . 35 


In order to solve for the warrant value we need to arbitrarily assume some warrant value.
Let’s assume that W0=$5.00. This would yield the following
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 UAV = 15 + 221 ⋅5 = 15.23

Maturity = 
 2 years 
22  
W0 = Call ( Black − Scholes ) X = 20 ⋅
22 + 1  R 
= 4 .0 %
 f


 σ = .35 


A call with these attributes has a value of $1.92. With the dilution of .9565
(22/23=.9565), the estimated warrant value is $1.83. This is not the W0 = $5.00 that we
started with. If we start with a warrant price of $1.83, going through all the steps yields a
warrant price of $1.77. If we now start with $1.77, we end up with $1.77. This is the
warrant price.