Valuing warrants
 

For fun I was reading through IPO's and came across the following:

Company is selling units for $12. One unit consists of a common share + a warrant allowing you to purchase one common share for $13.50 for a period of 3 years. First, knowing nothing else, is it possible to place an approximate value on the warrant?

What if the company is a close ended fund that has fees which seem far too high (2% + incentive payments if they increase the Net Asset Value of the company by >8%). Can we then put some value on the warrant?

Steve

P.S. I don't plan on investing in this company, just curious about the warrants.

Re: Valuing warrants
 

Re: Valuing warrants
 

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http://en.wikipedia.org/wiki/Black-Scholes

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Cool, thanks. Guess this is one of those things I should've just googled.

Re: Valuing warrants
 

I used to trade a ton of these things, it was a blast. Black scholes is a good way to value them for sure, but remember, they are often included in the offering as a "sweetener" and can put a damper on the stock price.

Re: Valuing warrants
 

If its an IPO, how do you decide what volatility to you use as an input?

Re: Valuing warrants
 

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If its an IPO, how do you decide what volatility to you use as an input?

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you can really only use a proxy, and scholes is ballpark estimate at best anyways.

we never used black scholes really, other than for academic reasons. just traded both by feel, generally got long the warrants and shorted some common as a hedge. depending on how bullish you were on the company you could adjust your hedge accordingly. Common ratios were 2:1 or 3:1. As warrants got further out of the money we would up the ratio as they got closer to the money/in the money we would decrease the ratio.

Re: Valuing warrants
 

warrant is just a call option... any fees associated with the fund can basically be treated as dividends, because a dividend hurts the value of a call option, the same way fees would. you have to estimate the future volatility of the stock (just estimate the one standard deviation daily move of a stock and multiply it by sqrt(252)) and plug that into one of the many option calulators on the internet. For the dividend yield just use the fee (so 2% approx) and add any other dividends the fund might collect.

The reason a dividend is bad for a call option is that the stock will decrease by the dividend but since you are not an owner of the stock you do not receive the dividend... So the stock just goes down. Understanding options is not something that can be explained to you on a forum, read option pricing and volatility.

Re: Valuing warrants
 

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If its an IPO, how do you decide what volatility to you use as an input?

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you can really only use a proxy, and scholes is ballpark estimate at best anyways.

we never used black scholes really, other than for academic reasons. just traded both by feel, generally got long the warrants and shorted some common as a hedge. depending on how bullish you were on the company you could adjust your hedge accordingly. Common ratios were 2:1 or 3:1. As warrants got further out of the money we would up the ratio as they got closer to the money/in the money we would decrease the ratio.

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if you were heding your exposure to stock movement, if a stock IP0s at $12 and you are only selling 1/4 - 1/3rd of to hedge your exposure for a 3 year option with a $13.5 strike you are very likely actually long the stock and not really hedged. seems like the delta of this option has to be far higher than $50, given the fact that the forward price is going to be right around $13.5.

Re: Valuing warrants
 

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warrant is just a call option...

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if there's a significant amount of the warrants outstanding, so that they can cause significant dilution when exercised, pricing them as "just a call option" would be incorrect.

Re: Valuing warrants
 

fair point... I had the impression that if the stock price shoots up and the company knows warrants will be exercised, they will generally buy back stock to prevent dilution? still I think you are best off approaching this problem treating the warrant as a call option and then adjusting...