Lecture 6

Lecture 6 - Treatment of Warrants and Convertibles Warrants...

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Treatment of Warrants and Convertibles Warrants and conversion options (in convertible bonds, for instance) are long term call options, but standard option pricing models are based upon the assumption that exercising an option does not affect the value of the underlying asset. This may be true for listed options on stocks, but it is not true for warrants and convertibles, since their exercise increases the number of shares outstanding and brings in fresh cash into the firm, both of which will affect the stock price. The expected negative impact (dilution) of exercise will make warrants less valuable than otherwise similar call options. The adjustment for dilution in the Black-Scholes to the stock price involves three steps: Step 1: The stock price is adjusted for the expected dilution from warrant exercise. Dilution-adjusted S = (S n s +W n w ) / n s where, S = Current value of the stock n w = Number of warrants outstanding W = Market value of warrants outstanding n s = Number of shares outstanding
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