BAC: Warrants vs Stock

September 20th, 2010 by Potato

Larry McDonald pointed me to the Chou funds latest letter which describes buying into the US banks, in particular via the warrants that were issued to the US treasury in the bailout (and are now being publicly traded).

As it happens, I’ve been looking into the US banks (BAC in particular) on the theory that the worst is behind them now, and the pain is yet to come for Canada’s banks. I’m still a long way away from actually buying anything because it’s a very difficult sector to wrap one’s head around, especially in another country. However, this notion of the warrants was interesting so I decided to take a quick look.

The warrants (BAC.WS.A) allow you to buy a share of BAC for $13 and change in the distant future — 2019. They have an interesting feature in that the strike price is reduced by any dividends above the current 1 cent/qtr, so you don’t run the risk of the company paying out all the profits in dividends and the stock price going nowhere. Though warrants are very similar to call options, you don’t need to have an options-trading account to trade them. So far it sounds like an interesting option, especially if they’re cheap.

To see if it’s cheap, I need some way of modeling how much the warrant should be. That’s a tricky problem, one even the pros grapple with. Warrants provide leverage: for $7.50, I can buy the future upside to a stock that’s currently $13. So if I have $13, I can either buy nearly twice as many warrants, or one warrant and one safe security. However, with warrants you have to not only get the general direction right, but also the timing and the magnitude. I made a graph to very quickly look at what the return would be from either just buying and holding the stock, or buying the warrant, based on what the stock is at 9 years from now.

Return from buying either the warrants or common stock of BAC, very simplified model. No idea why the lines look wavy, it's a linear approximation.

Here the formula I used was:
For going long: (future price – current price)/current price for a cumulative return in %.
For the warrant: If future price was less than the strike price of $13, -100% (warrant expires worthless), else (future price – strike price – warrant price)/warrant price.

Now this starts to give an idea of the situation: if BAC shoots the lights out, the warrants are the better way to go, thanks to the leverage. If they just muddle through, then just going long would be better. The cross-over point is at approximately $30.50, which would represent a compound gain of roughly 10%/year. I haven’t finished my research yet (which is going slowly thanks to that other research), but I’m not sure I’d be quite that bullish on it.

I am obviously not doing this according to industry standards, as nowhere do I have any greek letters, or volatility, or what-have-you. I haven’t taken into account the time value of money, though I’m not quite sure I need to with this method. This is just a quick back-of-the-excel-sheet type estimation to look at what would happen with these warrants, and under what conditions they may be lucrative. Right now, it looks like one needs to be pretty bullish (~10%/yr for ~9 years running!) on BAC for the warrants to do better than the stock; but if you’re very bullish, then the leverage may start looking good.

Another obvious point is that I’m not going to run out and buy some warrants since I clearly don’t fully understand them yet… but it’s all part of the learning process!

Edit: The maturity is in January 2019, so it’s really only 8 years plus a few months. I haven’t gone back to fix any of the figures.

2 Responses to “BAC: Warrants vs Stock”

  1. Rachelle Says:

    Dear Mr. Potato Head,

    I love warrants and that’s about the only thing I trade. For more information about warrants try

    Most investors know nothing about warrants, they are mostly bought by large institutional investors. This means big buys and because warrants are not very liquid, you can just sit around on the sell side and wait for them to buy. (and jack up the price)

    My target is 100% profit and I often buy warrants listed at .005 and trade them for .01 a profit of 100%. You have to have patience in spades.

    Another strategy is to buy the warrant for a stock you think will go up. Some very impressive companies have warrants including Canadian Western Bank, Franco Nevada Mines and more.

    You can control a lot more stock with warrants than if you buy common. Take for instance junior miners… they spike up, they go down and disappear and are very volatile. Timing is a problem. The warrant tracks the share.

    I usually put my warrants for sale the same day I bought them for 100% more and just wait. Then rinse repeat.

    There are only a little over a hundred warrants in Canada. For me tracking these is a lot more manageable than the entire stock market :)

  2. Netbug Says:

    (nono, I get most of this… but it’s way above my investing understanding at this point)