Recently the Treasury began auctioning off the warrants acquired in the bank bailouts of 2008. Generally speaking, these are 9 year warrants to purchase the common stock of these various banks struck near the money. Warrant pricing is very similar to option pricing.
So how cheap or expensive were these warrants? Professionals have various models to value these securities with analysts focusing on 10 year estimates of dividend growth, forecasted volatility and interest rates. Since these instruments are outside of horizon of most if not all retail investors can we still tell whether these are cheap or not.
One way to view their cheapness is to analyze these warrants in terms of a covered call or buy write strategy. A buy write strategy consists of purchasing a share of common stock and selling a call representing the equivalent number of shares owned simultaneously.
Let’s look at JPM warrants. The auction took place in early December 2009. The Warrants were auctioned off at $10.59 per warrant with the common trading at $ 41.27. The warrant strike price was set at $42.42 per share of common.
We buy 1000 shares of JPM at $41.27 and simultaneously sell 1000 warrants (short) at $10.59.
We plan to hold this position until October 28, 2018, when the warrant will price at parity if JPM is above $42.42 or the warrant will be worthless with the common below that price of $42.42. A graph showing period returns and breakevens appears below, courtesy of ivolatility.com.
The chart above depicts returns and risk based on a very rosy scenario of a return to nearly historic annual dividends of $1.20 from the current $.20 annually. In the best case, JPM will pay out $1.20 per year and in late 2018 will be trading above $42.42. The annualized return would be 11.2% (not including commissions). Alternatively if the stock were unchanged ($41.27) at the end of the period. The warrant would be worthless and your return would be approximately 8.9%. In fact even if the stock declined the warrant premium and dividends would protect you from loss down to $16 dollars a share.
I have inserted a table below depicting a few different assumptions for analyzing potential returns on this strategy.
You’ll notice on the right side of the table the columns entitled “ preferred yield” an“9 year debt” (JPM corp bonds). (There should also be another column entitled “10 year Treasuries”, not included because of space issues, which currently remains empty). These columns are key to the intuitive valuation of the buy write strategy versus the general risk return characteristics of risk free instruments and other parts of JPM capital structure like preferred stock or bonds.
Case two is the second one down in the table and uses current dividend yield. The buy write strategy looks awful compared to owning the JPM bond with the same maturity. So either the dividend assumption is too low or the warrant premium is too low, or both. We have already agreed that case three is too rosy. Case one assumes a $1 dollar dividend annually over the next 9 years, which is definitely possible, yet this still only produces a best case return of 7.44 % annualized over the next 9 years and is far down in the capital structure relative to bonds and preferred. My sense is that there are better deals around but some investors may be interested in this strategy and its returns.
Remember, our goal was to see if the warrants were expensive or cheap with having an option model or making 9 year volatility assumptions or projections. From this analysis it is clear these returns are not outstanding, only okay, so we can safely assume that the warrants aren’t expensive. It is also clear that dividends would have to increase substantially to make the buy write strategy work. Also, if you have a general concern about interest rates being too low because of Fed intervention, then these returns are also too low adjusted for risk. This is another sign of the cheapness of the warrants.
Using this form of analysis, we declare these warrants cheap.