Published September 8, 2008
WARRANT INSIGHTS
Understanding dividend adjustments

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READERS should be familiar by now with the variables that affect a warrant's price: the underlying share price, exercise price, time to expiry, and implied volatility. These factors are often discussed and well understood.
There is, however, another variable that investors may be less familiar with, and which sometimes causes confusion in the market. We're talking about dividend payments.
In a well-functioning capital market, stock prices should incorporate some estimate of future dividends. In fact, when a warrant is issued, the pricing model takes into account an ordinary dividend expected to be paid during its life span. As a result, if the company actually pays the expected amount, there will be no change to the warrant's price.
Confusion arises when the payment is different than forecast or when a special dividend is paid. Or, to put it another way, if there is an unexpected alteration to the company's future cash flow, an adjustment has to be made.
The best way to understand unanticipated dividend payments is to think of things this way: a larger outflow lowers the value of a company, so call warrants have to be adjusted downwards and puts upwards.
Conversely, if the dividend outflow is less than anticipated, the value of a company is higher, so the calls have to be adjusted upwards and puts downwards.
Most issuers, however, will try to maintain the warrant's price without having to make such adjustments, especially since customers could be caught unprepared by any sudden adjustment to prices. They do this by changing the exercise price and conversion ratio to ensure the warrant's price remains stable.
For a call, this means lowering the exercise price and increasing the number of shares that each warrant is entitled to by the same proportion.
The net effect is that the price remains unaffected after a special dividend is paid, which is probably the fairest way of compensating warrant holders for an unexpected drop in share price.