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INTRODUCTION This chapter examines the characteristics and valuation of
options and option-related financing
It explores the concepts necessary to evaluate the impact that decisions to issue or purchase these type of securities have on shareholder wealth
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DERIVATIVE SECURITIES
As the name implies, all derivative securities derive their price from some underlying asset
Derivative securities provide a mechanism whereby companies can: Lay-off risk they don’t want Assume additional risk, with the expectation of earning a
return
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TYPES OF OPTION-LIKE SECURITIES
Calls and puts
Convertible fixed-income securities
Warrants
Bond refunding
Rights offering
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TYPES OF OPTIONS
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Call Option
Right to buy an asset at a
known price for a fixed period of
time
Put Option
Right to sell an asset at a
known price for a fixed period of
time
IMPORTANT OPTION FEATURES The cost to purchase an option is known as the premium,
which the buyer must pay up front.
All options must be sold or exercised prior to their expiry date, or they become worthless.
The price at which the asset is bought/sold under the option contract is the exercise price.
To the buyer, the option represents the right, not the obligation to undergo an action.
The option writer (or seller) has an obligation to perform if the buyer decides to exercise option. 7
CALL OPTION EXERCISE
To exercise a call option, the buyer must pay to the writer of the option the exercise price
In return, the writer must deliver to the buyer the underlying asset (such as a common stock)
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PUT OPTION EXERCISE
To exercise a put option, the buyer must deliver to the writer the underlying asset (such as a common stock)
In return, the writer must pay to the buyer the exercise price
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VARIABLES AFFECTING OPTION VALUE
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Variables affectingVariables affectingthe value of an optionthe value of an option
Stock Price
ExpirationDate
Price Volatility
InterestRates
ExercisePrice
VARIABLES AFFECTING OPTION VALUE
Increase to Variable: Effect on Call Option Prices
Effect on Put Option Prices
Share Price ↑ ↓Exercise Price ↓ ↑Volatility ↑ ↑Risk-free interest rate ↑ ↓Expiration date ↑ ↑
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CALL OPTION VALUATION
Call option value (C) equals the greater of: Share price (S) – Exercise price (X) Zero In compact notation, C=max{S-X, 0}
Maximum possible value at expiration: Share price
Minimum value at all times Zero
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CALL OPTION: MIN, MAX & MARKET VALUES
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Max. Option Value:
Stock Price
Min. Option Value:
Option Value on Expiration Date
Market price prior to
Expiration Date
Exercise Price
Share Price
Call Option Value
CONVERTIBLE SECURITIES A convertible security is convertible into common stock,
usually at the option of the holder
Conversion ratio Number of shares obtained in conversion
Conversion premium Conversion price is usually greater than stock’s market price when
convertible is issued
Par ValueConversion ratio =
Conversion Price
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REASONS FOR ISSUING CONVERTIBLES Make security more attractive – buyer can participate in the
company’s success but with less risk than buying equity today
Sell common shares in the future at a price greater than today’s market price
Allow time for investments to generate value
Makes owning securities in small, risky companies more attractive Lessens the agency conflict between bond holders and shareholders
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VALUATION OF CONVERTIBLES
Conversion value Conversion ratio times the share price
Investment value Equals the straight bond value
Market value Equals the price the security trades for on the market Usually slightly above the higher of the conversion value or
the investment value Difference is the premium
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VALUATION OF CONVERTIBLES
17Share Price
Value Conversion Value
Bond or Investment Value
Market Price
WARRANTS Allows the holder to purchase additional common shares for
some period of time at a fixed exercise price
Usually issued as a sweetener attached to other securities
Exercise price Price at which common stock may be purchased Usually 10% to 35% above the market price when the warrants
are issued
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WARRANTS Expiration date
Date when the option to purchase ends 5–10 years
Usually trade separately from the underlying security
Provide leverage to investors (similar to a long-dated call option)
Market value of warrant Usually exceeds the difference between the stock price and
exercise price (its intrinsic value) The difference is called the time value premium
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WARRANTS
On the expiry date, the value of the warrant is equal to its intrinsic value, which is:
Prior to the expiry date, the warrant trades above this price. The longer the time before expiry and the greater the volatility of the price of the common stock, the greater the premium above intrinsic value.
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÷
Warrant Common
Stock
Number ofP =Max $0; P -Exercise Price ×Shares Obtainable
with each Warrant
WARRANTS VS. CONVERTIBLE SECURITIES
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Characteristic W C
Lessen Agency Conflicts x x
Deferred Issuance of Common Shares x x
Savings of Interest or Dividends x x
Company Receives Additional Funds x
Two Securities on Books x
More Control x
RIGHTS OFFERING
An offer to sell new equity to a firm’s existing shareholders.
Each shareholder can acquire new shares in an equal proportion to their current ownership.
Formally known as the Preemptive Right. If firm’s charter contains a Preemptive Right clause, the firm
must first offer to sell any new equity to existing shareholders
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RIGHTS OFFERING
One right is issued for each share owned
To acquire a new share, holder must submit the subscription price plus X rights
Subscription price set below current market price at time of issue (or the holder would not have an incentive to exercise the right)
Rights are issued attached to the common stock. Stock initially trades rights-on or cum-rights.
When rights trade separate from the common stock, the stock is said to trade ex-rights.
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RIGHTS OFFERING
Example:
The Miller Company has 10 million shares outstanding, which currently trade at $40. It plans to sell 1 million new shares via a rights offering, with a subscription price of $35. In this case, each right entitles the holder to purchase 0.1 new shares. Thus it takes 10 rights plus $35 to purchase one new share.
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VALUATION OF RIGHTS
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Theoretical Value:Selling Rights-on
−=+
0M SR
N 1
Theoretical Value:Selling ex-Rights
−= eM SR
N
M0 = Rights-on market price of shareMe = Ex-rights market price of shareS = Subscription priceN = Number of rights needed for share purchase
RIGHTS
A shareholder must either exercise or sell their rights, prior to the expiry date, or she will lose a portion of her wealth
Since a right is very similar to a short call option, its market value will typically be somewhat above its theoretical value prior to the expiry date.
It will trade at its theoretical value on the expiry date
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SWAPS A swap is a contractual agreement between two parties to
make periodic payments to each other
Two major types of swaps Interest rate swaps Currency swaps
Interest rate swaps allow a firm to either reduce or increase interest rate risk (the risk arising from a change in interest rates)
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INTEREST RATE SWAPS: TYPICAL USE
Company has a fixed rate asset and a floating rate liability. It is exposed to the risk that interest rates might rise.
To reduce risk, company may enter into a swap whereby it exchanges its floating rate liability for a fixed rate liability, thereby reducing interest rate risk
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INTEREST RATE SWAPS: EXAMPLE
Company A has a fixed rate bond with a 10% coupon. It wants to swap this fixed rate liability for a floating rate liability.
Company B has a floating rate bond on which it pays LIBOR plus 1%. It wants to exchange this floating rate liability for a fixed rate liability.
A bank acts as a mediary to help Company A and Company B arrange a swap.
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INTEREST RATE SWAPS: ILLUSTRATION
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10% Fixed Rate Bond
Floating Rate Bond
(LIBOR + 1%)
CompanyA Bank
CompanyB
LIBOR LIBOR
FixedRate
FixedRate
PartialOffset
PartialOffset
MAJOR POINTS
The price of all derivative securities is derived from the price of some underlying asset.
Options give the holder the right but not the obligation to undertake some action.
Options exist in many forms, such as call & puts, warrants, rights and convertible securities.
Swaps allow companies to exchange cash flows to reduce (or assume) risk.
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