Many investors still perceive options as instruments which are used for outright speculation on the direction of a certain underlying value, with the opportunity to make fast and large profits, but also the chance to lose the initial investment as fast, or even faster. This is particularly the case when an investor weighs the alternative outcomes between, for example, an investment of $1,000 in 20 Wal-Mart (WMT) shares or the purchase for an equivalent amount of 4 call options expiring in April with an exercise price of $50, which currently have a price of about $2.50 per option.
When on the expiration date the share price of Wal-Mart has increased to $55, profit on the shares position will be $100, while the options will have doubled in value. But if the share price has not increased to a level above $50, the whole investment in options will be lost. 
This is just one way of using options; in truth, there are many ways in which options can be utilized while defining investment strategies. It is even possible to construct risk-free options positions, where the return should be equivalent to the return on a risk-free cash instrument. In practice this is not easy, since investors have to pay transaction costs, but mainly because of the fact that part of the advantage will be lost due to the spread between bid and ask prices of options.
If there is a choice between highly speculative positions on one side and risk-free positions on the other side, it must be possible to choose a position between these extremes that corresponds with the risk/reward expectations of an investor at a given time. However, it needs to be clear that it is not possible to achieve additional returns without incurring additional risks. Every investor has to ask himself always if certain risks are acceptable, and if the compensation for accepting these risks is adequate. The interesting thing about using options is that in principle almost every view on a certain underlying value can be translated into an investment strategy.
The possibility to sell put options in order to increase the return on cash positions will be discussed here. With this strategy the risk must be accepted that on the expiration date the underlying value must be purchased at the strike price. Under the present stock market conditions this can be an interesting strategy, since there are already so many negative expectations in share prices. The major indices are substantially down from the levels at the end of 2007, and this has been accompanied with a sharp increase of option premiums. The compensation for absorbing negative share price risks has increased, while the chance that we have come closer to the bottom may have increased.
With this strategy I prefer to choose shares of companies with a solid long term performance and a good dividend yield. In case shares with these characteristics have to be purchased through exercise of the options, there is a reasonable chance that at the price level at which the underlying shares must be purchased, they are a good long term investment.
As an example I have chosen Wells Fargo & Company (WFC), which is considered to be one of the stronger banks. It is also a major holding of Berkshire Hathaway (BRK.A), giving it the support of investor Warren Buffett. At the time of writing the share price of Wells Fargo was $32.60, giving it a dividend yield of about 3.8%. The table below shows how the achievable returns relate to the chosen strike price of put options expiring in January 2009. 
In the most cautious scenario, put-options with a strike price of $15 could be chosen. When an investor sells these options, he runs the risk that on the expiration date in January 2009, shares must be purchased for a price of $15. Compared to the current share price this is a discount of 54%. An amount of $14.76 needs to be invested in order to have this $15 available at the expiration date. The option premium contributes $0.65 while the investor must add $14.11 from his own funds. This amount is more than adequate for any margin obligations on the short position. On the expiration date in December it is possible that either the investment with accrued interest of $15 is fully available again to the investor, or that he is obliged buy shares at a strike price of $15.
When the share price is above $15, the investor will keep his money and he will have achieved a return of 6.3% in about 10 months, which is 7.6% on an annual basis. This is a substantially higher return than would have been achieved with just keeping the cash holdings invested in money market instruments. In case the share price has fallen below $15, the investor must purchase the shares, and may achieve a dividend yield of 8.3%, when dividends have not been adjusted. This is well above both cash returns, and the current dividend yield.
When a strike price of $20 is selected, the annual return can be increased to 10.3%, while a price decrease of Wells Fargo shares of almost 39% in the next 10 months is still acceptable, without jeopardizing the calculated return.
An even higher strike price can be selected, with the possibility of higher returns. The vulnerability with respect to price movements of the underlying shares will however become much greater, and therefore also the chance that a price decrease of the shares will lead to a forced purchase of the shares through the exercise of the put options. For an investor who is actively looking for a good entry point for purchasing the shares this may be attractive, aided by high option premiums. For an investor who is seeking additional returns with moderate risks, these higher strike prices will most likely be less attractive.
Disclosure: None
Monday, March 24, 2008
Option-Charged Savings for Current Market Conditions
Tuesday, March 4, 2008
The final price for Corporate Express
Imagine you go to the casino and spot a big bucket filled with 100 balls. There are 51 red balls and 49 blue balls. Next to the bucket there is a sign which informs you that you can guess the color of a randomly drawn ball for $1. If you are right, you will receive $2, but if you are wrong you will lose your bet. A rational investor will take a seat next to this bucket and will not leave anymore. By consistently betting on a red ball being drawn, he can calculate a 51% chance of achieving a return of $2 and a 49% chance of a return of $0, which gives an expected return of $1.02 for an investment of $1.
We can apply the methodology of this simple probability calculation to determine what the expected value of the acquisition by Staples of Corporate Express will be. In this case there are a couple of complications, and we need to make some extra assumptions to make the calculation.
The easy part is determining the value of the bet, which is equal to the actual stock price of Corporate Express. At the time of writing this was about 7.80 Euro, a premium of 7.5% in comparison with the offer from Staples of 7.25 Euro. Subsequently we can calculate how much a rational investor wants to receive when the acquisition is finalized. I assume closing of the acquisition will not take place before the end of May, which means that Corporate Express shareholders will have received a dividend of 0.21 Euro before this closing. The rational investor, who is only concerned with probability calculations, will expect to receive at least an amount of approximately 7.87 Euro at the end of May, assuming an interest rate for short term Euro deposits of 4%. At the end of April, he will already have received 0.21 Euro, which implies that the remainder of 7.66 Euro has to come from his bet on the outcome of the draw from the bucket of balls.
We still need to determine the probability of the outcomes and the values of the outcomes of the draw. Since Corporate Express was trading in a range of 5.00 - 5.50 Euro before the offer from Staples, I assume the share price could drop to 5.00 Euro again, if the acquisition fails to take place. I assign this outcome a probability of 20%. We still don’t know the value of a successful offer, but we do know that the rational investor wishes to receive at least 7.66 Euro. Knowing this, we can calculate the value of the expected offer, which has a chance of 80%. The calculation is (7.66 – (0.20 x 5)) / 0.80 = 8.33. With this offer price, an investor has a chance of 20% to receive 5 .00 Euro, and a chance of 80% to receive 8.33 Euro. This gives an expected return of 7.66 Euro, exactly his minimum requirement. Including dividend, the offer would have to be 8.54 Euro.
If we would assign a chance of 70% to a successful offer, the acquisition price would need to be 9.02 Euro, while an expected chance of 90% of success gives an acquisition price of 8.17 Euro.
The conclusion is that the rational calculating investor, who is presently considering to take a position in Corporate Express for a price of 7.80 Euro, and who assigns a 80% chance of success for the acquisition to take place, expects a final offer of 8.54 Euro, including dividend. If the offer fails, this investor will expect the share price could drop back to 5.00 Euro.
I believe that most current shareholders of Corporate Express are rational calculating investors, and that they believe a revised offer needs to be at least somewhere in the 8-9 Euro range to be successful. If Staples is serious about its intentions to acquire Corporate Express, it is hard to imagine that they would not have expected that an increased offer would be required. If this is the case, the indicated range should not come as a surprise either.
Monday, March 3, 2008
BofA/Countrywide Merger Arbitrage Opportunity
On January 11th, Bank of America (BAC) announced a definitive agreement to purchase Countrywide Financial (CFC) in an all-stock transaction valued at approximately $4 billion. Under the terms of the agreement, shareholders of Countrywide will receive 0.1822 shares of Bank of America for each share in Countrywide. At the time of announcement, parties expected the deal to be completed in the third quarter of 2008.
This merger agreement followed an investment by Bank of America in Countrywide, announced on August 22nd of last year, in which Bank of America made a $2 billion strategic investment in Countrywide. This was done through a 7.25% non-voting convertible preferred security, with a conversion price of $18 per share. With the merger announcement almost five months later, Countrywide is valued at just over $7 per share.
Arguments have been made both in favor of the deal and against the deal. The main argument in favor of Bank of America is that they are acquiring Countrywide at a very attractive price, with a valuation far below book value, while they get access to the mortgage capabilities, including distribution networks of Countrywide. These assets are expected to be very profitable again once the dust in the credit markets settles. Bank of America also expects substantial cost savings from the merger. The argument against the deal for Bank of America is the fact that there still may be more and unpredictable losses to come, while also the completely different corporate cultures may be an issue.
The argument in favor of the deal for Countrywide is that they really had no choice and would have gone into bankruptcy without a bailout from Bank of America, who already came to the rescue in August last year. The argument against the deal for Countrywide is the fact that the company is sold far below book value and that the purchase price does not properly reflect the profit potential of the company. In other words, what may be a good deal for Bank of America shareholders may be a not so good deal for Countrywide shareholders.
Although I am fully convinced of the intentions of Bank of America, it has been argued that the SEC filings can be interpreted in such a way that Bank of America effectively has a call option on Countrywide. The argument is that there is enough wording in the document to allow Bank of America to walk away from the deal if dramatic adverse developments take place in Countrywide before closing of the deal. Interestingly enough, Countrywide also seems to have a put option on Bank of America, as Bill Miller noted in his latest letter to shareholders of the Legg Mason Value Trust. Shareholders of Countrywide can still turn down the deal and even at a later stage a potential termination fee of $160 million, or 4% of the current deal value, does not seem insurmountable should business developments increase significantly and a better opportunity presents itself to Countrywide shareholders. The proposed merger agreement explicitly allows for the possibility to negotiate a restructuring of the transaction and resubmission to Countrywide shareholders, in case they do not approve of the current proposal. If the deal were to indeed fall through, Bank of America would, of course, still have its $2 billion investment in Countrywide, which would otherwise disappear when the merger does take place.
With this background in mind, and realizing that we are still many months away from closing, an awful lot can still happen with respect to the turmoil in financial markets that may influence the final outcome of this deal. Maybe it would be interesting to turn to the market in order to determine how the current deal is perceived. The graph below (left) shows the discount of the actual share price of Countrywide measured against the actual share price of Bank of America, multiplied with the conversion factor of 0.1822. The graph on the right is almost a mirror image of the other graph, but represents the value that can be realized by short selling 1 Bank of America share and buying 5.49 shares of Countrywide. At finalization of the merger, this position in Countrywide shares should generate exactly enough shares of Bank of America to offset the short position.
At the end of trading on January 11th, the closing share price for Countrywide and Bank of America was $6.33 and $38.50 respectively. With the conversion factor of 0.1822, the theoretical value of Countrywide shares was $7.01, meaning that Countrywide ended the trading day with a discount of -9.8% to its acquisition price. In the week after the announcement, this discount increased sharply to a level of -24.3%. When Countrywide announced the results for the fourth quarter of 2007 on January 29th, Bank of America confirmed its commitment to buy Countrywide and called the announced losses “consistent with our due diligence”.
Subsequently on January 31st SRM Global Fund announced it had acquired a stake of 5.48% in Countrywide, and believed that the merger agreement significantly undervalues Countrywide. The price discount rapidly decreased to a level of just -7.4%. Since that day, the discount has increased again and has been within a range of -10% to -15% for the last 4 weeks, with a level of -12.9% at the end of February. The graph on the right side shows that after the announcement on January 11th, positive cash flow could have been generated of $3.76, followed by low of $3.32 and high of $8.75 in the period until the end of February. This shows that new information and different perceptions in the market about the likelihood of the merger, even in the short period since the announcement, have already lead to significant opportunities and risks.
A similar merger arbitrage position as described above can also be constructed with options. Instead of short selling Bank of America shares, an investor can sell call options and buy put options with the same maturity date and exercise price. In the same way, Countrywide call options can be purchased and put options sold as an alternative to buying the shares. The following example shows the different outcomes, based on observed prices on Friday afternoon, February 29th.
Bank of America shares were trading at a price of $39.92 and Countrywide was trading at $6.22.With these prices, the sale of 1 share of Bank of America and the purchase of 5.49 shares of Countrywide gives a positive cash flow of $5.77. With the use of options the following could be achieved:
Sell 1 Call BAC Jan’09 40 @ 4.90 +4.90
Buy 1 Put BAC Jan’09 40 @ 6.60 -6.60
Buy 5.49 Call CFC Jan’09 5 @ 2.00 -10.98
Sell 5.49 Put CFC Jan’09 5 @ 1.00 +5.49
Net cash flow -7.19
The maturity date of January 2009 was selected because it is after the third quarter in 2008 and it is the first month with expiry of options in both Countrywide and Bank of America. In this example, it is assumed that the merger is effective immediately after the expiry of the options, but this is not very relevant. In case the merger takes place before the expiry of options, the positions can be reversed and a similar return as calculated here will be achieved.
On expiry and exercise of the relevant in-the-money options, the investor will pay 5.49 x $5 = $27.45 for the Countrywide shares and receive $40 for the delivery of Bank of America shares. These shares will net against each other in the merger closing and the investor keeps the difference of $12.55, which is $5.36 higher than his initial investment. The difference between the value of $5.77 and this calculated $5.36 is caused by the effect of dividend, time and price spreads.
The advantage of the options strategy is that an investor may tweak the structure to reflect his own preferences and / or expectations, by changing maturity dates, strike prices and number of options traded.
It is possible that the discount of the Countrywide share price versus the acquisition price will become very stable while gradually moving to 0% as the planned finalization date in the third quarter approaches. With the current uncertainty in financial markets, and the certainty that much knowledge and many new facts will come to the market in the months ahead, I would however not be surprised if we still see quite some movement of the discount before we reach the final outcome of this merger. As we have seen, the level of this discount will have a significant effect on the returns that can be achieved with a merger arbitrage position on this deal.