Most investors think they understand options. Fewer have spent time thinking carefully about warrants. Fewer still have asked what really distinguishes the two.
Warrants are simply call options issued by the company itself, rather than written by a third-party counterparty in a listed options market. When warrants are exercises, the company issues new stock. Now, consider two stocks of identical companies:
Case 1: Stock A has a listed call option outstanding, Stock B has a warrant outstanding. The contracts have identical terms (strike, expiration, exercise style), and the two companies are otherwise indistinguishable. This is not a trick, the two stocks have identical characteristics (drift, volatility, skew).
Question: What is worth more? The call on Stock A, or the warrant on Stock B?
Case 2: A Single Company with Both a Warrant and a Call Option. Now change the setup. Suppose one company has both a listed call option and a warrant outstanding simultaneously, with identical contractual terms.
Question: Which is worth more now? The call, or the warrant?
The answers are under the image below.
Case 1: Because warrants dilute the firm upon exercise, a warrant must be worth less than an otherwise identical call option.
Case 2: The call option perfectly hedges the warrant in the case of exercise and no exercise, therefore they must be worth the same for no arbitrage to hold.
Another way to think about case 2 is that the market should be pricing in the dilution roughly equal to the number of underlying shares in the warrant times its delta. In fact, for case 1, even if the companies were identical businesses with identical initial share prices, the stock of company B would be expected to drift up at a slower rate than company A due to increased dilution risk as the spot moves up.
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