Covered warrant valuation: a costly hedging model

We provide a new, supply-side explanation for the consistent, statistically significant, empirical observation that covered warrant prices are higher than those of corresponding traded options. Covered warrant market-makers, who set prices, are also the issuers and always have net short positions. Their reservation prices for redeeming or issuing more warrants reflect the change in their total hedgingrelated costs. For overall net short positions we show both bid and ask reservation prices lie above perfect-market values, since transaction costs increase both issuers’ marginal costs of warrant issuance and the marginal benefits of warrant redemption. The model generates prices and bid-ask spreads consistent with existing empirical evidence and also new testable implications