Pricing of Warrants with Stock Price Dependent Threshold Conditions

Abstract

Warrants with stock price dependent threshold conditions give the right to buy specially issued stocks, if the performance of the stock price satisfies some requirements. Existence of these derivatives changes the price process of the underlying. We show that in the presence of such warrants one cannot assume that the stock market is arbitrage free and that the stock is tradeable at every time moment with the same price for buying and selling. This means that the usual methods for deriving fair prices for such warrants cannot be used. We start from a simple model for the firm’s value process and discuss some ways to specify a related model for the stock price process in the presence of warrants with threshold conditions. We also discuss how indifference pricing approach can be used for pricing such warrants.