okay we have a good topic today we're
back to the roots of this channel which
is financial derivatives and how they
work if you haven't yet seen the news jp
morgan is suing tesla for 162 million
claiming that tesla failed to make a
required payment that was triggered
after elon musk's announcement that he
was taking the company private back in
2018.
in the court filing jp morgan says that
warrants sold by tesla to jp morgan had
required the bank to make adjustments
after musk said on twitter that he had
funding secured to acquire the company
at 420 a share when tesla later
announced that it was abandoning the
transaction the value of the warrants
once again changed and jp morgan was
again obliged to adjust its position the
whole lawsuit relates to a convertible
bond that was issued by tesla back in
2014
convertible bonds if you don't know are
a type of bond that the holder can
convert into shares of common stock in
the issuing company or the cash
equivalent value at an agreed upon price
they typically have a low coupon or at
least lower than otherwise similar debt
but they carry additional value through
the option to convert the bond into
stock this embedded option is a warrant
rather than a call option and the
biggest difference between a warrant and
a call option is that warrants create
dilution as when their exercise the
company issues new equity to deliver to
the warrant holder a simple way of
thinking of it is that when you make
money through a call option the money
that you made comes from the trader who
sold you that option with a warrant the
person on the other side of the trade is
the company whose stock the derivative
is based on the more money you make the
more that company loses and so the stock
that they have to deliver to you has its
price beaten down by the losses that
they've taken so warrants are worth a
bit less than call options for this
reason if you want to learn more about
financial derivatives like this check
out my book derivatives for the trading
floor
there's an amazon link to that in the
video description okay so now that we
know what convertible bonds are and that
they contain a warrant let's look at the
convertible bond in question
tesla sold 1.38 billion dollars of seven
year convertible bonds with a one and a
quarter percent coupon and a conversion
price of 359.87
back in 2014.
these prices are all prior to the five
to one stock split that has since
happened so to adjust these to today's
prices you just have to divide them by
five the stock was trading at around 250
at the time so for the warrants to be in
the money the stock had to go up around
44
now usually the reason that companies
issue convertible bonds is that they
want to issue bonds or borrow money but
they don't like how high the interest
rate on that debt will be so they make
the bond convertible to get a lower
interest rate now they often want to set
the conversion price as high as possible
but the problem with that is that the
higher you move the conversion price the
less the warrant is worth and thus the
higher the interest rate you'll have to
pay
but maybe more importantly there's just
a point at which convertible bond
investors are just not interested in the
bond at all if the conversion price is
too high the way tesla worked around
this was to issue that convertible bond
and then buy an option from the banks
that mirrors the embedded option it had
the same strike price and expiration
date as the warrant thus hedging the
warrant of course at this point you
might as well not have issued a
convertible bond at all right so they
then sold the banks a separate warrant
at a higher strike price the way this
combination works is that bond investors
got the type of convertible bond they
wanted with a low enough conversion
price and tesla got to raise capital by
selling a structure that gives them the
exposure of a convertible bond with a
much higher conversion price the the
strike price that they originally had
wanted
now the bank who facilitated this
transaction has what's known as a call
spread on their hands they're short the
low strike call option they sold that to
tesla and their long
higher strike warrant which they bought
from tesla in this case the banks were
short a seven year option on 3.8 million
shares with a strike price of 359.87
and long a seven year warrant on 3.8
million shares with a strike price of
560.64
once again all of these prices are
pre-stock split tesla will have had to
pay the banks for this spread and the
banks were left exposed to the stock
price risk of tesla stock then the banks
will of course then hedge this risk by
delta hedging their stock price exposure
which then leaves them exposed to the
volatility or standard deviation of
tesla's stock price the more volatile a
stock is the more expensive options and
warrants are the banks were long
volatility through the warrant in
question which means that the more the
stock price moves around the more money
that they make through their hedging
activity their biggest risk is the tesla
becomes less volatile over the life of
the warrant and then their hedging would
not make them back the cost of the
warrant some of this stuff can be a
little bit complex okay so tesla's stock
was and is volatile which will have made
the warrants that the bank bought from
tesla expensive as long as the stock
stays volatile that's fine but an
obvious risk from a bank's perspective
is that something could happen to kill
the volatility of the stock one thing
that can make a volatile stock a lot
less volatile is a merger announcement
as once a deal is announced that a stock
will be bought out we'll say at a fixed
price the stock price moves close to
that price and then slowly drifts to the
price with very little volatility until
the day the deal closes
if instead there was a stock for stock
deal let's say a small car maker like
toyota decided to buy a big car company
like tesla exchanging toyota shares for
tesla shares that would likely severely
reduce the volatility too and that would
have been bad for the bank who is
hedging the warrants the warrants in
question were over the counter
derivatives done under an isda agreement
which is standardized legal
documentation in the world of
over-the-counter derivatives the
agreement takes into account obvious
risks like mergers and acquisitions it's
totally standard to have an adjustment
provision in the case of a foreseeable
corporate action like an acquisition the
provision tends to give the bank broad
discretion to adjust the terms of the
warrant to keep its value the same the
bank can make such adjustment to the
exercise settlement payment or any other
terms of the warrant as it determines
appropriate to account for the economic
effect on the warrant of the
announcement of a merger including
adjustments to account for changes in
volatility expected dividends stock loan
rate or liquidity so what this means is
that if the bank has a hundred million
dollars worth of warrants and the
company ceo announces the next day that
the stock is being taken private the
bank is allowed to lower the strike
price of the warrant until it's worth a
hundred million dollars once again okay
so back to tesla's that's what we're
talking about here and many of you are
probably already down in the comments
section saying but patrick tesla was
never acquired but many of you might
also remember that back in 2018 the
techno king and meme lord of tesla elon
musk announced on his twitter feed that
he was going to take tesla private at
420 per share
should this have been taken seriously
well in a form 8k filed with the sec in
november 2013 tesla identified elon
musk's personal twitter account
as a source of material public
information about the company and they
encouraged investors to review that
account on top of that tesla's cfo its
head of communications and its general
counsel drafted an email detailing the
plan to go private which was published
on elon musk's twitter feed and tesla's
blog which tesla had also designated as
a source of material public information
about the company additionally elon told
stock analysts on a call that the offer
to take tesla private was as firm as it
gets in total the ceo and chairman of
tesla elon musk spent around three weeks
back in 2018 pretending that he was
taking tesla private at 420 dollars per
share elon musk finds the numbers 420
and 69 funny as do people on reddit but
as we can see in this lawsuit
derivatives traders and lawyers do not
find any numbers funny i've spent over
20 years in the finance industry and
have never accounted a trader who laughs
when they hear or see the number 420
that may be one of the key differences
between the tech and finance industries
when elon announced his deal back in
2018 jp morgan adjusted the strike on
the warrants down from 560
to 424.66
using a warrant pricing model which
adjusted for the lower expected
volatility associated with this deal a
few weeks later tesla announced that
musk was just joking and so jp morgan
adjusted the warrant again according to
their lawsuit jp morgan concluded that
the average implied volatility increased
by 5.74 points or 14.3 percent as a
result of the august 24 announcement and
determined that increasing the strike
price to 484.35
was the appropriate adjustment to
maintain the same pre-announcement fair
value for the 2021 warrens note that
this is a lower strike price than the
warren started out with and this is the
center of the
j.p dispute
notified tesla of each adjustment as
they were made in accordance with the
agreement and they provided
documentation explaining the
calculations tesla wrote back six months
later arguing that the adjustments were
unreasonably swift and represented an
opportunistic attempt to take advantage
of changes in volatility in tesla stock
now in truth that's basically the job
description of a derivatives trader if
you're ever interviewing for a job like
this you should probably include on your
cv that you're unreasonably swift and
opportunistic that'll go down well
according to the lawsuit tesla's letter
did not dispute that announcement events
had occurred it did not challenge any of
the specific calculations or supporting
materials jp morgan had provided six
months earlier and it did not offer any
support for its assertion that jp
morgan's methodology was unreasonable
anyhow though warrants expired in june
and july of this year they were deep in
the money no matter what strike price
you use but jp morgan claims that they
are owed 162 million dollars more than
tesla has paid them based on the strike
price adjustments that happened back in
2018. jp morgan was one of four banks
that acted as tesla's counterparties on
the warrant transactions for this
convertible bond deal and tesla claims
that none of the three other warrant
dealers made similar adjustments of
course the other banks had much smaller
positions than jp morgan had and they
might have written off the adjustments
in order to keep a big customer happy
the other three banks might hope to make
more money in ongoing business from
tesla than what was written off from jp
morgan's perspective it may make better
business sense to go after the 162
million dollars as they would likely
never earn that much money from tesla
firm future corporate finance
transactions i'm not a legal expert so
i'll let you guys tell me in the comment
section who should win this case it
would appear that the case hinges on
whether it was reasonable to take elon's
tweet seriously tesla don't appear to be
disputing their calculations it's worth
noting as well that the stock turned out
to be more volatile than expected rather
than less volatile over the life of the
warrens some of this might be down to
the fact that a company having a ceo who
pretends to do transactions at prices
that he finds funny makes a stock price
move around a lot more than having a
more serious techno king tweeting about
corporate actions if you enjoyed this
video you should watch this one next see
you again soon bye
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