Petrobank spinoff: what happens to an option contract? (updated)

Update 29 December 2010:  Please note that Montreal Stock Exchanged has clarified these issues in a PDF document:  the contracts are now trading under the ticker PBG1.  The value of each contract is essentially what I predicted in this post.  Each contract is now based upon the following:

100 common shares of Petrobank (PBG) and 61 common shares of New Petrominerales (PMG) and a cash portion equivalent to 0.5 common share of PMG


Original post:

I have sold some April puts on Petrobank.  Yesterday they announced the spinoff of their holdings in Petrominerales of which they own 60%.  According to the Globe and Mail, Petrobank holders will receive shares Petrominerales when the arrangement closes before December 31:

The subsidiary, which produces oil in Colombia, saw its shares climb by almost 7 per cent. Following the reorganization, Petrobank shareholders will receive approximately 0.62 shares of the former subsidiary, renamed New Petrominerales, for every share of Petrobank they currently own.

I’ve sold some put contracts of Petrobank, and I was wondering what happens to my options contracts in case they are in the money at expiration, since the new share price of Petrobank will obviously adjust to reflect its value after the spinoff.  I found this answer at the International Securities Commission:

Corporate actions such as mergers, acquisitions and spinoffs will often necessitate a change to the amount or name of security that is deliverable under the terms of the contract. When such adjustments occur, the short call position is responsible for delivering the adjusted security.

For example: The shareholders of company JKL Inc. have approved a takeover bid placed by Global Giant Co. As a result, holders of JKL stock will now be entitled to a 1/2 share of Global Giant for every share of JKL Inc. they own. Therefore, holders of JKL call options will now be entitled to a deliverable amount of 50 shares of Global Giant for every contract of JKL that they are long (100 shares per contract x .5 Global Giant). Investors with short positions in JKL call options would then be responsible for delivering 50 shares of Global Giant for every call option assigned.

If I am correct, if my shares are assigned, I will receive at the strike 100 shares of Petrobank for each April contract in the money; I would also receive 62 shares of New Petrominerales.  Those exercising a call contract would receive the same.  I don’t know how the  price would be calculated, but I assume the combined market price on expiry of 100 shares of Petrobank and of 62 shares of Petrominerales.  If anyone knows, please make a comment below.


Deflation or hyperinflation, an investment for both at the same time

During the market crash that began in June 2008 and ended in March of 2009, the TSX lost 50% of its peak value; the US indexes (cf. S&P 500; NASDAQ) experienced similar losses.  Other asset classes such as gold and the loonie suffered similar  losses against the mighty US dollar, as investors took a flight to “safety”.  Arguably this was a period of deflation, when most asset classes plummeted in value while the US dollar itself benefited.  It was also deflation caused by a shrinkage of credit, the sub-prime mortgage meltdown, which had the effect of reducing the quantity of money.

Since the beginning of this deflationary crisis, the US Federal Reserve has taken measures to reflate the US dollar through quantitative easing–which is the creation of new fiat currency.  Yesterday, Bernanke’s Federal Reserve promised to create another 600 billion greenbacks out of thin air, a spelling out of a promise that occurred already a couple weeks ago, causing the dollar to dive against gold, oil and foreign currencies.  This is probably only the beginning of the woes.  Some writers, such as Gonzalo Lira (see e.g., “How The Fed Gave Away $1.5 Trillion Through Stealth Monetization“), are predicting serious hyperinflation beginning in the first quarter of the new year.

Yet surprisingly, there remains a large number experts who believe that our biggest fear today is still deflation.  David Rosenberg issued another warning which appeared at the Business Insider on November 1:  “All This Talk Of Inflation Is Madness, DEFLATION Is Still The Big Threat“.

Clearly the investor needs a flexible strategy that hedges against inflation and deflation at the same time.  I personally believe that inflation is the way its going to go down; it is possible to create too much money and the Federal Reserve in its fear of another Great Depression is creating money to prevent it.  In my view, it does nothing helpful except to reduce debt by debasing the dollar.  All my life inflation has been the major threat and I’ve seen the dollar lose buying power consistently through the decades.  So I don’t really believe in deflation, particularly when Bernake has the creation of inflation as his goal.  He has no power to improve the economy, but he can destroy the dollar.

Yet because of Rosenberg’s (et al.) warning, I think it prudent to have a plan for deflation.  But how does an investor have a working strategy to beat inflation and deflation at the same time?  I’m not leaving my money in cash–that’s what you do when you believe that deflation is the only credible threat.  If you believe that inflation is the only credible threat, then you put everything into concrete assets like oil companies or real estate.  Debt is a marvelous asset class–provided that the debt is invested in a rental real estate (a mortgage) or dividend bearing stocks so that the interest can be paid.  So in fighting inflation I’m doing the following:


1. I maintain mortgage debt on a rental property.

2.  I maintain a stock portfolio which is 100% invested in Canadian oil and gas or gold-mining companies.

3. I maintain a positive Canadian cash balance and negative US dollar balance in my margin accounts.  As a Canadian investor, my total margin is calculated as a composite of the Canadian and US accounts.  I may hold Canadian equities in my US account.

4. I occasionally move assets from US dollar account into Canadian funds.


In order to protect against deflation:

1.  I maintain ample margins in my margin accounts.

2. I have my lines of credit which protect against a margin call.  In case of a Rosenberg-predicted double dip, I have to have something to fall back on, and that’s where the HELOCs come in (both on the rental property and on the primary residence).  Yesterday, I was able to obtain 30% increase in these lines.

3. I will take profits on gains and increase cash positions as market improves (in loonies not greenbacks).

4. In case of market depression, I will use the unused lines of credit to average down on equities.

In many cases, after the 2008 crash, I was able to pick up stocks at well below shareholder’s equity.  For example, I was picking up shares of Midway Energy, which had a book value of $3.40, as low as $0.39, which is an astounding .115 price to book ratio.  In market downturns, the stocks will be oversold, and bargains will be available.  Thus, at least half of the lines of credit must be reserved for purpose of averaging down during a market crash.  The other half, of course, is reserved to meet a margin call.  No debt or obligation (such as a possible assignment on put option) is covered by the margin alone but by cash or an outside line of credit as well.

This is an unconventional strategy.  But these are not conventional times.  Most of the investment strategies that I’ve seen continue to call for a balanced portfolio–balanced between stocks and fixed income investments (bonds, savings accounts, treasury notes, gics, etc.).  Those who were burned by stocks twice in less than a decade are now being told to ease back into “risky” assets because of the fear of inflation (see for example, Rob Carrick).  But I worry that most financial columnists and advisers are not taking the risk of hyperinflation seriously enough, and their readers or clients will be burnt as a result.

Please see my financial disclaimer.

All This Talk Of Inflation Is Madness, DEFLATION Is Still The Big Threat 

Read more: