Abstract

This study estimates option prices via a recombining binomial tree incorporating the effect of warrant dilution on the capital structure of the firm (Warrant Dilution Option-Pricing model--WDOP). The binomial lattice is constructed on the value of the firm under the assumption of constant volatility of the rate of return of the firm value. The mean percentage prediction error and the mean absolute value of the mean prediction error indicate that the predicted option prices deviate significantly from the observed option prices. The weak predicting performance of the WDOP model doesn't seem to follow a systematic pattern. This is true even when the sample is divided into subcategories based on option moneyness, and option and warrant life. We tested the WDOP model with one parameter, the volatility of the rate of return of the firm value, estimated out-of-sample. We compare the WDOP model with the Black Schole option-pricing model (hereafter B/S) applied to the options without taking into account the equity dilution effect. Finally, we calculate the warrant prices throughout the sample