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2
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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Options exist in many forms
S-T options on common stock Convertible fixed-income securities Warrants Rights Bonds with redemption provisions
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Option Exchanges
http://www.aantix.com/
http://www.cboe.com/
http://www.cbot.com/
http://www.cme.com/
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Call Option Valuation
At expiration = Stock price – Exercise price
Prior to expiration > Stock price – Exercise price
Maximum value = Stock price Minimum value = 0
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Variables Affecting Option Values
VariablesVariablesaffectingaffecting
the value ofthe value ofan optionan option
Time to Time to expiration dateexpiration date
Interestrates
Expected stockprice volatility
Exercise priceExercise priceStock priceStock price
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Convertible Securities
Debentures and preferred stock Terms of conversion represented in
conversion price. Conversion ratio
Number of shares obtained in conversion Equals par value of security/Conversion
price Conversion premium Difference
Conversion price greater than stock price when security is issued.
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Reasons for Issuing Convertibles Make security more attractive Sell C/S in the future at higher price Allow time for investments to pay benefits Allows smaller, risky firms to acquire
capital Reduces agency conflicts
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Valuation of convertibles
Conversion value Equals Conversion ratio times the Stock
price 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 Investment value
Equals the straight bond value
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Option Valuation Calculator
Check out the option valuation calculator at this Web site:http://www.numa.com/
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Conversion
Conversion
Voluntary
Forced
Call privilegeCall privilege
Prior to expirationPrior to expiration
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Warrants
Usually issued with other securities Characteristics
Exercise price Price at which C/S may be purchased Usually 10% to 35% above market price
Expiration date Date when the option to purchase ends 5–10 years
Traded separately
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Warrants (continued)
Why issue warrants ? Sweetener
Provide leverage to investors
Market value of warrant Usually exceeds the formula value
The difference is called the premium
Warrants provide leverage to investors
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Warrants (W) and Convertible Securities (C)
Characteristic W C
Lessen Agency Conflicts x x
Deferred Issuance of C/S x x
Savings of Interest or Dividends x x
Company Receives AdditionalFunds
x o
Two Securities on BooksMore Control
x o
o x
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Rights Offering
A single right for each current share Subscription price is less than current
market price. Can sell rights Subject to a shareholder of record date
Rights-on Ex-rights
Rights trade for a price is greater than the theoretical value.
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Economic Value
R =Mo – S
N + 1
Theoretical value of a right selling rights-on:
R =Me – S
N
Theoretical value of a right detached:
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Interest Rate Swaps
Traded on the over-the-counter market Basic type
Exchange floating rate interest payments for fixed rate
Protects against fluctuations in interest rates Used to hedge against interest rate risk Longer-term risks – 10 years or more Parties to agreement
Finance company Bank Financial institutions
Floating Rate tied to LIBOR (Ch 2)