The Biggest Warrant Auction in U.S. History

by: Linus Wilson

88.4 million warrants to purchase JP Morgan Chase’s (NYSE:JPM)’s stock for $42.42 per share will be auctioned off on Thursday, December 10, 2009. Those warrants will begin trading on the NYSE under the ticker JPM-WS if the auction is successful.

This is a huge event for the U.S. options markets, according to Risk Magazine. Never have so many warrants hit the public markets at any one time. If the results from the Capital One Financial’s (NYSE:COF)’s auction are any guide, buyers of these long dated options probably can expect a bargain.

Given that the U.S. Treasury, which obtained these warrants as part of the bank bailout, set the minimum price that it will accept in the red herring prospectus at $8 per warrant, my range is from $8 to $17 per warrant. My best estimate is a winning bid of $9.75 per warrant or $859 million. I would not be unhappy if the price goes higher than my “best estimate.”

Yet, these estimates reflect the low prices obtained in the Capital One Financial (COF) warrant auction last week.

I estimate in my new paper, “The Biggest Warrant Auction in U.S. History,” that investors in Capital One’s warrants could reasonably expect returns of 10.7 percent if they hold the options until they exercise them and the volatility over next nine years is similar to volatility over the last ten years. Even better returns could have been had by people who made winning bids in the auction.

That is a pretty good return since with careful planning you can hedge out most of the stock price risk by writing shorter dated call options or shorting Captial One’s stock. Nevertheless such strategies would not be appropriate for novice investors. Brokers are charged with determining the suitability of warrant investing for potential bidders according to the prospectus. The minimum bid size is for 100 warrants. Similar returns may be possible for JP Morgan’s warrants depending on the auction’s and secondary market’s prices.

Volatility is how much the stock price moves around. Option prices rise with implied volatilities, very low implied volatilities indicate low prices or expectations of future volatility. I don’t think that investors should expect dramatically lower volatility in the future. The volatility of the stock market today is near its historic average. Yet, there is a huge 16 percent difference between the implied volatilities of the Capital One’s call options which expire in 2-years and the warrants that expire in 9-years. I expect a similarly large gap for the JP Morgan warrants. That means the warrants will probably be pretty cheap relative to JPM’s call options.

The JP Morgan Chase warrant auction takes place Thursday, December 10, 2009, from 8 A.M. to 6:30 P.M. The bidding strategies are similar to the Capital One warrant auction, and are described in my paper on page 4. All winning bidders pay the same price that clears the market.

Thus, if the minimum winning bid is $11 per warrant everybody that submitted a bid at $11 or higher pays $11. Details of the warrant contracts up for auction are in my paper’s Table 3. My estimates and methodology based on December 9, 2009, closing prices are there too.

Disclosure: This is not investment advice. Warrants take active management and may not be suitable investments for many investors. I do not plan to bid in the upcoming warrant auctions. I own broad-based index funds. I do not have long or short positions in individual securities issued by Capital One or JP Morgan Chase.