Warrants Overview Both Wells Fargo and Bank of America issued long dated warrants back in the depths of the great recession. The Wells Fargo warrant expires October 2018, while the Bank of America warrant expires in January 2019. The two graphs below depict the two-year performance of each of the warrant contracts compared to their underlying common shares. As can be seen the Wells Fargo warrants have outperformed the common by a widening margin, as the common shares have increased. The opposite can be said for the Bank of America warrants, as the common shares have increased; the warrants have underperformed by a widening margin. The asymmetric trends between these two warrants are interesting to explore. To better understand these trends I conducted an analysis of the underlying value of each warrant based on prices of May 31, 2015. Return Comparison Between Warrants The assumption I made was that the Bank of America warrants would offer better upside than the Wells Fargo warrants. The Bank of America warrants should in theory offer more upside as they have considerably more downside risk. A 20% decrease in the Bank of America current stock price, would render the warrants worthless. For Wells Fargo a 40% decrease in stock price would render the warrants worthless, this adds additional safety on a comparative basis. The interesting trend I discovered was that if both underlying stock increase the same amount on a percentage basis, the Wells Fargo warrants have a higher return. The reason for this I concluded to be, investors see a considerable more upside in the underlying value of Bank of America shares than in Wells Fargo shares. This seems to make sense as Bank of America is trading under tangible book value, while Wells Fargo trades at 1.77 times it’s tangible book value. The tables and charts below try to depict a picture of the returns of each warrant. Investment Rationale
It can be seen from the tables above that at the current prices, the Wells Fargo warrants look like a rewarding play. For Wells Fargo bulls the math is simple, a 21.54% return in the underlying common share results in a 53.92% return in your warrant investment. This would mean the stock has to average a 7% return over the next three years, this does not seem like an extraordinary event. The warrant investor’s return would be an annualized 18% return. However, any investor in these warrants needs to have considerable risk tolerance, as any correction in the market will result in magnified losses. The Bank of America warrants also have a rewarding return profile, and potentially greater upside. The greater upside arises from the fact that the underlying stock of Bank of America appears more undervalued. There is less downside protection on the Bank of America warrants, so investors have to tread carefully. Both these warrant investments seem like rewarding plays for an enterprising investor with these three characteristics: long term bull on banks, wants to achieve large returns, and one who has a tolerance for risk. Pair Trade Potential The reason for purchasing these warrants is the considerable outsized returns on the upside. As can be seen from the charts above, the divergence of the stock and warrant return becomes exponentially larger with increases in the underlying stocks. To protect yourself on the downside, without giving up too much upside, you can hedge the warrant trade. If you short the underlying stock and make a warrant investment, you can achieve a net long position. This would also protect some of, but not all of the downside potential. Another potential pair trades could be buying the warrants and selling long dated calls on either of the stocks. Or an investor could buy the warrants and buy long dated puts. The appeal of the warrant investment is enormous upside, but investors who want to temper their enthusiasm can utilize a pair trade to hedge the downside risk. If any reader would like me to explore a pair trade from a mathematic perspective, I can make an attempt to model the returns.
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AuthorRotman MBA Student interested in common stock investing, with a preference for high cash-flow businesses. Archives
December 2020
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