Companies sometimes issue convertible bonds. A convertible bond is a bond that can be converted into stock. Normally the conversion is at a fixed price that is above the price of the stock when the convertible is issued. In 2014, Tesla Motors Inc. (now Tesla Inc.) sold $1.38 billion of 7-year convertible bonds with a 1.25% coupon and a conversion price of $359.87, a 42.5% premium above its stock price of $252.54 at the time. (At the same time, it sold another $920 million of 5-year convertibles with a 0.25% coupon and the same 42.5% conversion premium, though I will not discuss those bonds further here.) When the bonds matured seven years later (this March 1), Tesla’s stock was trading at $718.43. But in between Tesla had done a 5-for-1 stock split, making the effective conversion price of the bonds about $71.97. One $1,000 bond converted at maturity into about $10,000 worth of stock. All the convertible bondholders converted by the time the bonds matured — some long before — and were happy and we will not talk about them anymore.
When a company issues a convertible bond, often it thinks: “This is fine, but I want a higher conversion premium. I don’t want people to be able to convert into my stock at 42.5% above my current stock price, because I think my stock will go up a lot. I want, like, a 100% conversion premium. I want to do a convertible that doesn’t dilute my stock unless my stock goes up a whole lot.” But this is hard to do, in the convertible bond market; convertible-bond investors don’t want to buy super-high-premium convertibles. So companies sometimes do what is called a “call options overlay,” or a “call spread,” or a “bond hedge and warrant transaction,” with their investment banks. In effect they buy an option from the banks (the “bond hedge”) that mirrors the conversion option in the convertible: In this case, Tesla’s $1.38 billion 7-year convertible would convert into about 3.8 million shares of stock, so Tesla bought a 7-year option on 3.8 million shares with a strike price of $359.87. (Those 3.8 million shares automatically became 19 million shares after the stock split.) And then they sell the banks a separate option (the “warrant”) at a higher strike price: In this case, Tesla sold the banks a 7ish-year warrant with a strike price of $560.6388, a 122% premium above the stock price when it issued the convertible bonds. The overall result is that the company has effectively issued a synthetic high-premium convertible: If the stock goes up 80% or 100%, it will issue some shares on the convertible but get them back from the bond hedge; it only “really” issues shares if the stock goes up more than 122% and the warrant is in the money.