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[Subscriber content from Barrons]
Wall Street derivative traders are wrestling today with how to value the new American International Group (ticker: AIG) warrants the insurer plans to issue later this month to its public shareholders.
Warrants are long-term call options. The value of the warrant is important to assessing the current value of AIG stock since shareholders will get just over 0.5 warrants for each share owned.
AIG stock has been strong lately, rising $1.40 to 61.85 today and up more than 40% since the start of December on hopes for the big insurer's revival and also thanks to the rising value of the AIG warrants.
AIG said today that it plans to issue 75 million of 10-year warrants with a strike price of $45 to its holders later this month, or 0.53 warrants, for each AIG share. When-issued warrant trading is expected to begin on Jan. 13 and the distribution is due on Jan. 19.
The current price of AIG stock reflects an assumption about the future share price of the shares after the warrant issuance and the value of the warrants themselves. AIG now appears to be discounting a stock price of around $48 and a warrant price of around $26 with holders getting almost $14 in warrant value per share.
A warrant price of $26 would be consistent with an implied volatility of AIG stock of around 35%, below recent volatility in the mid-to-high 40s, but way above the implied volatility of the options on insurers like Chubb that now trade with an implied volatility of around 20%.
Barron's has written that AIG was looking pricey trading in the high 50s ("AIG Shares Could Head Lower," Jan. 3), but the stock has continued to gain.
It's very complicated to analyze AIG now because it involves assumptions about the post-warrant value of the stock and the warrant value. We've argued that AIG stock looked rich because the shares, after the warrants are distributed, could be worth around 40, or about 80% of book value and roughly 10 times potential 2011 profits. That assumption could prove conservative, however. The market now is discounting a higher price.
One of the big issues in valuing the AIG warrants will be correct level of implied volatility, a critical input for analyzing and pricing options and warrants. JP Morgan has publicly traded seven-year warrants with a strike price of about 42 that trade around 14 with JP Morgan shares around 43. They have an implied volatility of around 30%. It's likely that AIG volatility will decline once the warrants are issued because the company will begin to resemble a regular insurer. That may weigh on the initial warrant price.
There is an enormous overhang of AIG stock that could weigh on the shares since the government owns 1.65 billion shares—92% of the total outstanding—and likely will begin to sell part of that stake during 2011.
Uncle Sam's stake in AIG could be worth $80 billion, dwarfing the value of its stake in either General Motors (GM) or Citigroup (C). Treasury has sold all of its Citi stock. The current float in AIG is worth just $8.5 billion, with $1.5 billion or more of that attributable to the warrants.
Adding up the value of these complex AIG instruments is proving to be tough even for Wall Street's quants, let alone the average investor.