Stochastic pricing formulation for hybrid equity warrants

Abstract

A warrant is a financial agreement that gives the right but not the responsibility, to buy or sell a security at a specific price prior to expiration. Many researchers inadvertently utilize call option pricing models to price equity warrants, such as the Black Scholes model which had been found to hold many shortcomings. This paper investigates the pricing of equity warrants under a hybrid model of Heston stochastic volatility together with stochastic interest rates from Cox-Ingersoll-Ross model. This work contributes to exploration of the combined effects of stochastic volatility and stochastic interest rates on pricing equity warrants which fills the gap in the current literature. Analytical pricing formulas for hybrid equity warrants are firstly derived using partial differential equation approaches. Further, to implement the pricing formula to realistic contexts, a calibration procedure is performed using local optimization method to estimate all parameters involved. We then conducted an empirical application of our pricing formula, the Black Scholes model, and the Noreen Wolfson model against the real market data. The comparison between these models is presented along with the investigation of the models' accuracy using statistical error measurements. The outcomes revealed that our proposed model gives the best performance which highlights the crucial elements of both stochastic volatility and stochastic interest rates in valuation of equity warrants. We also examine the warrants' moneyness and found that 96.875% of the warrants are in-the-money which gives positive returns to investors. Thus, it is beneficial for warrant holders concerned in purchasing warrants to elect the best warrant with the most profitable and more benefits at a future date.

Keywords

• equity warrants
• stochastic interest rate
• stochastic volatility
• heston-cir model
• hybrid model