Warrants as an Inflation Hedge?

[merkhet]

Has anyone thought about the possibility that long-term warrants that are in-the-money may act as inflation hedges? Any thoughts as to what parity might be on, say, GM warrants w/ a $18.33 strike and a "cost of leverage" of 1% might do if inflation hits 15% a year from now?

 

Would the cost of borrowing $18 for five years then be worth $18 and compensate for any reduction in price due to the reduction in price for GM common?

 

Then one has to wonder about issues such as volatility spiking up, etc.

 

Just a thought that I've been spitballing for a few days...

[blainehodder]

Hmmm.  I'm not really sure it acts as much of a hedge.

 

Here is the thing.... sure with a big near term uptick in the risk free the implied leverage becomes more expensive, and thus has a positive impact on the option value, but the uptick from rho will be painfully insignificant in comparison to the delta loss in the case of GM.  The  leveraged pain on GM's reduced earnings power in a high rate environment will certainly more than offset any positive effect of increased borrowing costs for the calls.

 

With WFC, you could in fact be amplifying both the underlying earnings power due to the rate increase (delta win), as well as celebrate the increased "cost of leverage" on the calls... any thought on this?

 

Of course, 15% rates would hopefully be backed by a ripping economy not a massively inflationary environment with slow growth, so you might not have much to worry about :)

 

I think focusing on the impact of rates on the underlying should be the primary concern.

 

EDIT: or just read Planmaesto's superior post!

[PlanMaestro]

Has anyone thought about the possibility that long-term warrants that are in-the-money may act as inflation hedgess?

 

Yes.  Though, I have the impression from the line of questioning that these are rhetorical and that you already know the answers. Right?  ;)

 

If not, or for the benefit of others, you can play with a B&S calculator like this one. I have not used it for the GM warrants, but I've done this kind of exercise for other warrants.

 

http://www.varcalc.com/calculators/varcalc/scripts/AmericanWarrantBAWDivCalculator.html

 

Any thoughts as to what parity might be on, say, GM warrants w/ a $18.33 strike and a "cost of leverage" of 1% might do if inflation hits 15% a year from now?

 

Yes. Depends on how real interest rates react. In a 70s scenario like you are suggesting, the real rates would probably be negative on a first  move… until the FED reacts Volcker-style and then the nominal go much higher, until the real becomes very positive, and equities woud go lower. But the first step might move the 10y treasury to 10-12%, for a negative real rate in the 3-5%.

 

Would the cost of borrowing $18 for five years then be worth $18 and compensate for any reduction in price due to the reduction in price for GM common?

 

In an inflationary scenario many of these companies would grow cash flows too. Some lower, some higher than inflation. That can compensate up to an extent a higher discount rate. I have a better feeling on this effect for some banks and insurance companies than GM.

 

How inflation plays out is well discussed in this book:

 

http://www.amazon.com/Unexpected-Returns-Understanding-Secular-Market/dp/1879384620/ref=la_B001K87MBQ_1_1?ie=UTF8&qid=1369334496&sr=1-1

 

But regarding your Q, a jump from 2% to 12% in interest rates can compensate for a LOT if you own the long-term warrants. The valuation that I have at hand (ZIONW) jumps 100% cetirus paribus. Or, in other words, it can compensate for a 33% drop in the price of the underlying common.

 

Then one has to wonder about issues such as volatility spiking up, etc.

 

Yes, and that too. It's nice to lock in an all-time-great combination of low interest rates and volatility for years.

 

And a little extra, that I'm sorry to say doesn't apply to GM. Dividends would increase with the increase in cash flows. Most probably a lot. The secret could be ridiculously good.

[merkhet]

blaine, perhaps inflation hedge was too narrow a focus -- rather the wording that I should have used was "Warrants as a hedge during an inflationary situation" -- it's not so much just that the "cost of leverage" would go up but that the combination of factors affecting the pricing of the warrants may offset any downward pricing fluctuation in the common.  Also, I chose GM merely because it's the warrant whose COL I knew off-hand as being ridiculously low... as you and Plan have pointed out, the exercise can be repeated for any of a number of TARP warrants...

 

Plan, it was only somewhat rhetorical in that I think I have a handle on what might happen, but I was curious to see the opinions of others. :P My guess is that GM will offer a dividend at some point in the future, and, if I'm not mistaken, those TARP warrant provisions on dividends (for all TARP money recipients) could be quite useful in an inflationary scenario...

 

In an inflationary situation, it would be rather interesting to see what happens to these TARP warrants, and if they do hold up fairly well (or increase in value *gasp*) in such a situation, it may be prudent to rotate out of the warrants and into the common...