Dividend protection at a price: lessons from endowment warrants

Abstract

The development of long term equity warrant markets has been hampered by the difficulty of providing dividend protection to investors in an easily understood form. A recent Australian innovation, the Endowment Warrant, has proved popular with retail investors because of its simple structure and because it is a call option providing a form of dividend protection. Despite its simple structure and investor appeal, valuation of the option is complex, since it is a long term option with a stochastic strike price (positively correlated with interest rate movements and negatively correlated to dividends paid on the underlying stock). Hoang, Powell and Shi (HPS, 1999) interpreted such warrants as equivalent to a dividend protected call option, and developed a valuation formula in which dividends played no role, and which when tested, implied that such options were trading at fair prices. This paper reviews what is meant by dividend protection and demonstrates that endowment warrants provide only a form of partial dividend protection. Consequently, the HPS formula is incorrect and leads to significant overvaluation. Estimates of the degree of over valuation by the HPS formula are provided, casting light on the cost of incomplete dividend protection to investors, and indicating that the warrants issued have traded at prices significantly in excess of their fair value (contrary to HPS's finding). Some possible causes of this divergence, and lessons for the construction of new securities are discussed.