ERICOPOLY

In a few words, I can say that Bank of America fit this description because the cancer was the expenses in runoff at LAS, the NewBAC expenses in runoff, and the legal settlements. Absent that, that bank was making reasonably good money. What is the good business at SHLD, and what is the cancer? The good operating business behind the cancer is which of their parts?

Actually, I got a slightly different result (compared to txlaw) from my modified formula. They were very close, but a little bit different. I wonder if it's due to this effect: 1) The common stock owner would be reinvesting the dividend into extra shares. Therefore the dividend needs to be multiplied by the FULL amount of shares. The total share count grows each year when the dividends are reinvested. 2) My computation that compounds the warrant strike by 6.5% takes this into account (I think). It grows the dividend effectively as if it were reinvested into additional shares, each paying 6.5% worth of missed dividend cost. Each year, the dividend cost is 6.5% bigger than the prior year because there are more shares. Do you agree that makes sense? If you ignore the effect of the missed dividend growing each year (due to the increasing share count of reinvested dividends), then the computation comes out wrong. So I think if you want best accuracy you can't simply add 6.5% to .69%. It's relatively close though, but for the sake of exactness it misses by a bit. so this is still my best stab at it: 17.65*1.x^5.5=18.33*1.065^5.5 EDIT: Well, it's better than nothing because it does at least recognize that the share count is rising after each dividend. However, it might not be adjusting the share count properly because it would depend on how many shares are purchased with the dividend. A higher stock price would result in fewer added shares, and a lower stock price would result in greater added shares. This is why the BAC "A" warrant dividend protection formula takes into account stock price when it adjusts the warrants for paid dividends. So, now how do you adjust the formula when you can get more than one share per warrant? weeeeee..... You don't need to. The gap in value is on the initial share, not on the additional shares from dividend reinvestment formula. In other words, there is no option premium assigned to those additional shares as they are bought with the dividend. So you only need to compute the rate of compounding to close the gap on the initial share purchased. EDIT: the "gap" I'm referring to is the option premium. You subtract it off the strike price, then get a number. At what rate does that number compound to get back to strike? That's the cost of leverage from the option premium alone. That rate doesn't change even after the warrant has undergone the dividend reinvestment simulation that results in higher number of shares at conversion.

That decision by GM is interesting. Imported cars are very expensive in Australia due to the import duties. What if there are no longer any domestically produced cars?

Regarding their cost of labor... I remember in the late 1990s (around 1999) my Australian engineer cousins were envious about our pay rates here in the US. Did that change?

Looks like they want to stimulate the economy by lowering the Australian dollar instead of cutting rates: http://finance.yahoo.com/news/aud-usd-dives-below-0-135000747.html The Australian Dollar took an unexpected spill this morning after Reserve Bank of Australia Governor Glenn Stevens surprised markets with overly dovish commentary. Noting that the economy won't likely be influenced by further rate cuts, Governor Stevens suggested that the economy would fare better if the AUDUSD traded closer to $0.8500. I would tend to believe that foreign property investors would hate this kind of thinking.

Actually, I got a slightly different result (compared to txlaw) from my modified formula. They were very close, but a little bit different. I wonder if it's due to this effect: 1) The common stock owner would be reinvesting the dividend into extra shares. Therefore the dividend needs to be multiplied by the FULL amount of shares. The total share count grows each year when the dividends are reinvested. 2) My computation that compounds the warrant strike by 6.5% takes this into account (I think). It grows the dividend effectively as if it were reinvested into additional shares, each paying 6.5% worth of missed dividend cost. Each year, the dividend cost is 6.5% bigger than the prior year because there are more shares. Do you agree that makes sense? If you ignore the effect of the missed dividend growing each year (due to the increasing share count of reinvested dividends), then the computation comes out wrong. So I think if you want best accuracy you can't simply add 6.5% to .69%. It's relatively close though, but for the sake of exactness it misses by a bit. so this is still my best stab at it: 17.65*1.x^5.5=18.33*1.065^5.5 EDIT: Well, it's better than nothing because it does at least recognize that the share count is rising after each dividend. However, it might not be adjusting the share count properly because it would depend on how many shares are purchased with the dividend. A higher stock price would result in fewer added shares, and a lower stock price would result in greater added shares. This is why the BAC "A" warrant dividend protection formula takes into account stock price when it adjusts the warrants for paid dividends.

I rather prefer just using my first equation that computes the cost of the option premium. Take that result which is .69% Then add 6.5% Get result of 7.19% Much simpler than modifying that equation like I recently did -- which ultimately just makes it needlessly complicated

I believe it solves the problem where the dividends from the common are immediately reinvested into the common stock. I guess so, but you have to know the common price at those points to get an actual number, right? I see it like this. For the common, a $40 stock with $1 dividend. Now it's $1 in cash and $39 in stock. Reinvest the $1 into stock. Now you have $40 in stock. So for the common, just pretend like nothing ever happened (instantaneous reinvestment). $40 in stock is $40 in stock. Therefore, we only need to think about what effect the MISSED dividend has on the warrant. That's what my calculation does, by adjusting the strike price.

I believe it solves the problem where the dividends from the common are immediately reinvested into the common stock.

This seems to match txlaw's result: this time, I'm just taking 18.33 (the strike) and compounding it by the annual missed dividend rate. The reason why I think it makes sense to compound the strike price is because the first year's missed dividend expense get's compounded 4.5 more times, the second year's missed dividend expense get's compounded 3.5 more times, etc... So that effectively works in a way that it solves the time value of money problem. He used 1.20 for the annual dividend and therefore 6.5% for the annual dividend cost (1.20/18.33=.065) He used 68 cents for the option premium 18.33 is the option strike he used 5.5 years 18.33-.68=17.65 17.65*1.x^5.5=18.33*1.065^5.5 solving for x, I get about 7.19% annualized cost. That's 6.5%+.69%=7.19% .69% is the annualized cost of the option premium -- he estimated it to be 1%. It was just an estimate. I compute it to be .69% using my first equation which calculates it precisely (17.65*1.x^5.5=18.33). So we come to the same result. Hooray! EDIT: I reworded the explanation in the first paragraph

Here is another aspect of txlaw's calculation that differs: I'm not sure if he recognized it, but the formula I provided to Packer solves for that. It's a pretty easy formula to use. But that formula only tells you what the pre-paid interest really cost you -- it doesn't account for the cost of the lost dividends.

Anyways, to be nitpicky a missed 25 cent dividend paid out quarterly does not have the same cost as a missed $1 dividend paid out annually. However, I have only so much patience for being too exact.

I am only talking about how he deals with the cost of the lost dividend to the option. He's just saying that it cost a percentage of the strike price. So let's say you borrow $10 (the strike price) and you miss a $1 dividend. That's a 10% cost. Compare that to borrowing $10 from your local banker at a 10% interest rate. After a year, it cost you $1. So he's right about that, I think. The only time you have to worry about reinvestment of the dividend is when you are dealing with the common. So it's a problem for you to overcome when you are fixing up your spreadsheet, but it's not something that txlaw has to deal with because he didn't take a stab at the common.

I thought your way was an iteration back on Eric's--shouldn't you use Eric's new way to calculate it? I don't think so. They way I do it makes the most intuitive sense for calculating leverage to me. I think if Eric's way is right, our cost of leverage should come out the same (plus or minus NPV effects). I think it might have to do with you guys using a compound interest rate. But my brain is fried at this point. You and Eric are approaching it in a very different manner than I am, so I don't think I can comment too intelligently as to the way you are doing it. Perhaps Eric can. The compound interest rate is the right way to deal with the option premium (my first equation that I gave to Packer). However, I think my attempts to modify it today are stuffed up. By implication, since my second iteration today came to the same result as Racemize's spreadsheet, perhaps his spreadsheet too is stuffed up (if it comes to the same result). And I think they are stuffed up for the reason that Racemize and I both suspected -- the summing up of the dividends. We're acting like the missed dividend all comes at the end. As if it were one huge whopping dividend payment missed at the very end of the term. However, that's wrong, because the dividends are missed every step of the way. That meshes with txlaw's sustpicion that the error has to do with compounding rate. We can't use the compounding rate to deal with the missed dividends because we are doing no adjustment for the time value of the missed dividends. For example, $1 is 5% of $20. But if you compound $20 by 5% for two years, you don't get $22. Our methods of computing it therefore arrive at a different cost in the missing dividend scenario.

I have a feeling that it turns into one of the equations where you get the big greek Sigma letter in it.

I do indeed have the suspicion. No idea what to do with it though. But I think your model also has the same mistake. Because you don't do anything with your dividend, you're also effectively just summing it. Instead, you could be reinvesting it in the stock in real time as it gets paid out.

Ok, I'll do the same analysis as the prior post for this formula and see what it spits out: 17.75*1.x = 6.6+18.33 = 24.93 ----> 40.4% gross return This is exactly the same as my formula. I think we have a winner. Edit: Your formula is prettier/easier. sadface. I'm glad it comes to the same result as yours. Either it's right or we are both wrong. My first iteration had at least one significant problem 1) when Y was so big that it overwhelmed the number it was subtracted from -- that generates a negative number

Or it could be this: $17.75*1.x^5 = Y+$18.33 What's your opinion? I did have a large beer at lunch which is making this relatively more difficult. Would appreciate input. EDIT: Do you have a nagging suspicion that the dividends can't just be summed because their value depends on when they are paid out? Time value of money thing.

Okay, I'm done with my thinking on this now (I know, famous last words). Let's say you own a $10 call option and miss a $1 dividend. The value of your call option drops by $1. Now it's worth $9. It has to compound by 11.11% in order to get back to $10 value. So the cost of leverage (from this dividend alone) is actually 11.11%, not 10%. GM stock at todays close: $40.16 GM "B" warrant price: $22.41 GM "B" warrant strike: $18.33 Let Y = sum total of expected future dividends over the option period. Let X = cost of leverage rate $40.16 - $22.41 = $17.75 ($17.75 - Y)*1.x^5 = $18.33 I used time period of 5 years for simplicity, even though it's not exactly 5 years to expiry. Does this formula make sense to you guys? I introduced "Y" to account for the lost dividends.

Right... A couple of days have passed and I've decided the prior post I made was not thought out well enough. I realize now that in order for the warrant premium to be supported by an arbitrager writing calls, then that individual would need to find somebody to purchase those calls. But it would be irrational to purchase those calls due to the cost from the dividend -- so likely such a buyer doesn't exist. Oh well...

The background on how I came up with that equation... 1) I don't know how to use Excel, so I wasn't going to go there 2) I didn't want to have to plot two lines on a graph and find the point of intersection So I just reasoned that the option premium is a cost that would have to be overcome in order to do just as well as the common. So you subtract the option premium from the strike price to get a number. Then you just have to ask at what rate that number needs to compound to get back to the strike price. That rate will be the precise, exact breakeven point versus the regular common stock. Were it to come up short, you would have not met the option premium hurdle -- so it would certainly have underperformed the common. Were it to come up in excess of the options premium, then you would for certain have outperformed the common stock as you've exceeded the amount paid for the premium. Make sense? I'm not sure if it's in any text books or if it's used elsewhere -- probably, but I just came to this on my own out of avoidance of Excel. So the option premium results in a "hole" in the value versus the common if the stock never appreciates before expiry -- the only way to break even versus the common is to precisely fill in that hole.

The time premium of .68 -- I wonder what the market is expecting for dividend reinstatement? I expect the premium would decay at somewhat of an accelerated pace when a significant dividend is reinstated. So over a short time period that could easily get expensive. Or at least, no longer look like such a bargain. What if it went from .68 to zero in one month? Okay, perhaps an exaggerated example. And ultimately, it's only 68 cents so not that big of a deal -- but the cost of leverage on an annualized basis would be high. Still, it can't exceed 68 cents -- leverage costs can be high for short periods and it's not a big deal in the grand picture of things.

Yes. It sounded good in theory to believe one could just write LEAPs as an arbitrage on the warrant dividend, but it may be hard to find such an idiot to purchase the LEAPs in real-time.

Yes, I was trying to figure that out this morning. I'm not sure I've reached any solid conclusions. Let's say the BAC has a $1 dividend and the leaps start having a cost of leverage of 7% due solely to the missed dividends. Would we expect it to trade at a higher cost of leverage than 7%? Perhaps, but I guess we could ignore it now for now. So if someone is looking at Leaps with a 7% dividend-adjusted cost of leverage, and the warrants are trading at 5% dividend-adjusted cost of leverage, then clearly the buyer would go for the warrants. (Unless they wanted less raw gains and a shorter duration). I guess I was thinking (and I think this is what you are saying) that the warrants should trade at least at the same cost of leverage as the Leaps? How much is there a possibility that the cost is just too high and people stop writing LEAPs? Probably, people would still be writing them in some amounts, but that's a lot of cost, since it is 7% for dividends plus any additional expected gains. People would perhaps still be writing the LEAPS (they could buy the common and write the LEAP -- collecting the dividend on the common and profiting on the harm done to the LEAPS). But why would someone want to purchase the LEAPS? I think that's what you meant?

I could be wrong about how much the arbitrage supports the warrants. Let's say I try to do this arbitrage. I purchase the warrant and write a call. What price will I get for the call? For a high dividend scenario, who is going to do this trade without wanting to buy the call for a slightly negative option premium? Once he's bought it, he exercises it and sells the underlying, thereby locking in his negative premium. But that leaves my warrant unhedged again. Hmm... What if instead the warrant is simply supported by the lowest-cost strategy of hedged leverage? I mean, suppose a trader is using portfolio margin an puts to leverage the common. Further suppose the cost of leverage in his strategy is only 3%. Won't this guy be motivated to short the warrants? His arbitrage would be to earn the spread on cost of leverage between the two strategies. Although he would have a cost of borrow for the warrant that he is shorting. Complicating his trade would be the rising volatility premium in the warrants if the stock pulled back down near warrant strike. But his strike prices on his margined stock puts could be quite high -- providing protection. Like for example, if we're talking about BAC at $30 and he is doing this arbitrage with $20 strike puts.... and if that's only costing him 3%, then it would seem to negate some worry. Of course, he takes on interest rate risk still and of course he is paying cost to borrow the warrants for shorting. Maybe somebody who isn't just rambling could chime in.