The risk-shifting effect and the value of a warrant

Differently from options, the exercise of a warrant leads to the well known dilution phenomenon, whose effects have been extensively studied over the last four decades. Though, the large debate is totally concentrated on the wealth transfer and the consequent price dilution occurring after warrant conversion, but inadequate attention has attracted the risk-shifting effect (i.e. the decrease of stock volatility following a warrant issue). In this paper, we argue that the use of a CEV model with an opportune elasticity parameter can consistently model the return volatility path for a firm with warrants outstanding. Consistently with the Efficient Market ypothesis, we are able to derive the optimal CEV parameter and obtain a closed solution formula for warrant pricing. The model only requires known market parameters, so avoiding the annoying problem of using unobservable variables, as suggested by many previous studies. A simulation and an empirical test provide evidence that our model outperform both Black and Scholes and the square-root CEV model.