A new market was created on Thursday night: the long-dated warrant market in Capital One’s (COF) formerly Troubled Asset Relief Program (TARP) warrants. Warrants are call options issued by companies, which allow investors to buy stock at preset strike or exercise price.
I’m glad that prices are being discovered by markets instead of government officials, bankers, or academics. The taxpayers received fair market value, net proceeds of $146.5 million, as part of their risky investment in Capital One Financial. Prior to Friday, I am aware of no publicly traded warrants in the United States with expirations in excess of five years. Therefore, Thursdays’ auction and Friday’s trading resolves much uncertainty about the pricing of long-dated warrants.
Winning bidders in the auction paid a uniform price of $11.75 per warrant. Those investors saw the value of their warrants rise to as high as $13.00 in the first hour of trading to fall to $12.25 at the close. 1.67 million warrants changed hands on Friday. Those prices were much lower than my previous estimates. Thus, I have revised substantially downward my estimates for future warrant auctions. Investors were prepared to pay for volatility of 41% per year for two-year options in Capital One Financial, but they only paid about 25% for 9-year warrants. Higher volatilities mean higher option premiums or prices.
Still the JP Morgan Chase (JPM) TARP warrant auction, which CNBC is reporting will happen this week and will certainly occur before the end of December, is on track to be the biggest warrant auction in U.S. history in both nominal and real terms. It should top the $311 million, or $675 million in 2009 dollars, received from the 1983 Chrysler warrant auction. (The 1983 Chrysler auction also produced a very low implied volatility relative to traded options.)
My revised estimates based in part on the secondary market trading prices of the COF warrants points to $7 to $18 per warrant for the 88.4 million warrants coming to auction. I use the Black-Scholes model adjusted for dividends and dilution from warrant exercise. These low estimates for the JP Morgan auction cannot go much lower without creating an obvious arbitrage between the January 2012 call options with a strike price of $45, which were trading at $6.25 on Friday. If the warrant prices fall below the January 2012 $45 call then an investor can seemingly make risk-less profits by buying the warrant with a longer time to expiration and lower strike price and shorting the January 2012, $45 call.
I’m sure the JP Morgan auction will be interesting. I will keep you posted.