Valuing Exotic Options Used in Underwriter Compensation

Options, often issued to the underwriter of unit IPOs, provide an interesting application of exotic option valuation. These options, which are generally for a unit or bundle of share(s) and warrant(s), are usually redeemable so that the underwriter option on the unit represents an up and out call, a form of an exotic option. Attempts to value these warrants are hampered by the fact that the underlying security is not publicly traded prior to the issuance of the option. For valuation purposes, FINRA (formerly NASD) guidelines for underwriter compensation use a simple formula that assumes a very low implied volatility. Volatility assumptions implied by this formula are significantly lower than those levels observed for unit IPOs. We value the underwriter option using a variant of the Black-Scholes (1972) option pricing formula for up and out call options under several alternative volatility assumptions. We find that the valuation using this methodology is significantly higher than the valuation derived under FINRA guidelines for valuing underwriter compensation. [PUBLICATION ABSTRACT]