Monday, December 19, 2011

How much has Buffet lost on BofA?

In typical NewsCorp form, a Wall Street Journal headline states that:

"Warren Buffett Is $1.5 Billion Underwater on His Bank of America Stock

Huh?  I said to myself, I didn't think Warren had bought B of A common - his recent deal involved preferred stock and warrants.

Reading a bit further into the article reveals that in fact that author is talking about Warren's position in warrants and not in common stock.  The headline is not only misleading, it's pretty inaccurate as well.  

As a side note, the funny thing though is that the Business Insider Blog presumably didn't read it all the way through when this post first appeared.  The article was rewritten with the apology that "This article originally stated that Buffett had lost money on his investment. We apologize for the error."

Anyhow, back to Warren's warrants.   To state that he is $1.5 Billion underwater is a bit of a stretch.  He bought 700 million warrants at a strike price of $7.14.  The current B of A stock price is currently about $5.00.  So  (7.14-5)*700 million = $1.5 Billion.

But this doesn't mean that he has lost $1.5 Billion on the options.  As my MBA students should know, how much an option changes in value for a $1 change in the underlying stock price is given by the option's delta.  Only if the delta equaled 1 would Warren's warrants have declined by $1.5 Billion.  

Valuing these long term options is pretty tricky, but if we assume a delta of say 0.5 (which is probably reasonably close) then the decline in value of Warren's warrants is about (7.14-5)*700*0.5 = $ 750 Million.  Still a lot of money, but not as much as reported before.

For extra credit - under what circumstances could these warrants have actually increased in value?  Hint (we'd need to see a major increase in one of the other Black Scholes inputs).  For even more extra credit - how would this change have affected his other investment in the preferred stock?