Chapter Derivatives,

19 Convertibles,
and Warrants

Prepared by:

Terry Fegarty
Seneca College

McGraw-Hill Ryerson ©2003©McGraw-Hill Ryerson

2003 McGraw-Hill RyersonLimited
Limited
 PPT 19-2

Chapter 19 - Outline
 Derivatives
 The Forward
 The Future
 Option Terms
 Options Issued by Corporations
 Convertible Securities
 Convertible Terminology
 Advantages and Disadvantages of Convertible Securities
 Warrants
 Use of Warrants in Corporate Finance
 Summary and Conclusions
© 2003 McGraw-Hill Ryerson Limited
 PPT 19-3
Derivatives

Derivatives
 contracts giving the holder the right to buy or sell an
asset at a guaranteed price, at some time in the future
 assets include commodities, foreign exchange,

interest futures, stocks, etc.

 include forwards, futures, and options

 become more or less valuable as underlying asset

changes in price
 investor can buy derivative for capital appreciation

or to reduce risk

© 2003 McGraw-Hill Ryerson Limited

 PPT 19-4

The Forward
Corn price ($US) Cash received

Forward

Agreed delivery of 500,000 bushels $2.29 US$1,145,000 guaranteed

Could be $2.90 US$1,450,000 possible

Or 2.00 US$1,000,000 possible

© 2003 McGraw-Hill Ryerson Limited

 PPT 19-5

The Future
Corn price ($US) Cash received
Forward (from previous section)
Agreed delivery of 500,000 bushels . . . . . . . . . $2.29 US$1,145,000 guaranteed
In September
Sell corn at
Cash (spot) rate . . . . . . . . . . . . . . . . . . . . . . . 2.00 US$1,000,000
Close out future
Future (Sept. expiry)
Sold at . . . . . . . . . . . . . . . . . . . . . . . . . . 2.28 US$1,140,000
Purchase at . . . . . . . . . . . . . . . . . . . . . 2.02 US$1,010,000
Gain (loss) on future . . . . . . . . . . . . . . . . . . . . . 0.26 US$ 130,000

Total revenues with cash market and future US$1,130,000

© 2003 McGraw-Hill Ryerson Limited

 PPT 19-6

Options Issued by Corporations

 purpose is to raise money

 include rights, warrants, convertible securities

 give the holder the option to buy or convert to

common shares of the corporation for a fixed

(exercise) price up to a preset date
 holder can exercise the option, sell it, or let it expire

 become valuable when the market price of shares

exceeds the exercise price

 trade in financial markets

© 2003 McGraw-Hill Ryerson Limited

Options …

© 2003 McGraw-Hill Ryerson Limited

 PPT 19-13
Option Terms
Call option
 gives the holder the right to buy an underlying asset at a preset price
Put option
 gives the holder the right to sell an underlying asset
Underlying asset
 the commodity, currency, bond, stock, or other asset that is deliverable under the
option contract
Exercise or strike price
 the preset price at which the underlying asset can be bought or sold
Premium
 the price at which the option is bought or sold
Intrinsic value
 the minimum value of an option
Speculative (time value) premium
 the difference between the premium and the intrinsic value
© 2003 McGraw-Hill Ryerson Limited
 PPT 19-14
Convertible Securities

Convertible security:
 a hybrid security combining features of debt and common
equity

 a bond or share of preferred stock than can be converted into

common stock at the option of the holder

 goes up in value if the common stock price increases

 the holder receives a fixed rate of return before converting

 banks are biggest issuers of convertible preferred shares

© 2003 McGraw-Hill Ryerson Limited
Advantages and Disadvantages PPT 19-15

of Convertible Securities

Advantages to the corporation:

 lower interest rate than on a straight bond

 may be the only means for a small corporation to sell bonds

 attractive to a corporation that believes its stock is currently

undervalued
Disadvantages to the corporation:
 average size of a convertible offering is very small

 accounting considerations regarding convertibles (potential

dilution of EPS)
© 2003 McGraw-Hill Ryerson Limited
 PPT 19-16

Convertible Terminology

Conversion Ratio:
 number of shares of common stock into which the
security may be converted
Conversion Price:
 face (par ) value of bond / conversion ratio
Conversion Value:
 conversion ratio x market price of common stock
Conversion Premium:
 difference between the market value and the
conversion value
© 2003 McGraw-Hill Ryerson Limited
Figure 19-3 PPT 19-17
Price movement pattern for a convertible
bond
Bond values ($)

1400
Market price
1200 of convertible
bond
1000 Pure bond value
$785.18
800
Conversion
600 premium

400 Conversion value

200

10 20 30 40 50 60 70
Price of common stock ($)
© 2003 McGraw-Hill Ryerson Limited
 Table 19-1 PPT 19-18
Pricing patterns for convertible
debentures outstanding, May 2002
Yield to Maturity on
Issue, Coupon, Conversion Market Yield to Bonds of Similar Risk
and Maturity Rating Value Value Maturity and Maturity

George Weston
3%
June 2023 A $1,713.60 $1,739.00n.a. 6.93%

Inco
7.75%
March 2016 BBB(low) 499.30 1,000.00 7.75 8.68

Noranda
5%
April 2007 BBB(high) 631.62 930.00 6.63 6.35

© 2003 McGraw-Hill Ryerson Limited

 PPT 19-19

Warrants

Warrant:
 an option to buy a stated number of shares of
common stock at a specified price over a given time
period (a long-term option to buy stock)
 may be attached to another security issue. Investor

can usually detach and sell separately

 may be issued “stand-alone”

 is highly speculative for the investor, as its value is

dependent on the market movement of the stock

 has a large potential for appreciation if the price of

the stock goes up

© 2003 McGraw-Hill Ryerson Limited
Table 19-4 PPT 19-20
Relationships determining warrant prices,
March 2002

(1) (2) (3) (4) (5) (6) (7)

Intrinsic Speculative
Warrant Share Exercise Value Premium
Firm Price Price Price (3) – (4) (2) – (5) Expiry Date

Inco (N .WT) . . . . . . . . . . . . . . . . . . $8.45 $30.53 $30.00 $0.53 $7.92 Aug. 2006

Toxin Alert (YTX.WTA) . . . . . . . . 0.20 1.35 4.50 0.00 0.20 Mar. 2003

Tech of Sterilization (TOS.WT) . . 0.20 2.40 2.50 0.00 0.20 Dec. 2002

www.cdnx.com
www.tse.com

© 2003 McGraw-Hill Ryerson Limited

 PPT 19-21
Figure 19-4
Market price relationships for a warrant
Value of warrant ($)

40

30 Market value
of warrant
20 Intrinsic value
Speculative of warrant
10 premium

0
10 20 30 40 50 60
Price of common stock
-10

-20

© 2003 McGraw-Hill Ryerson Limited

 PPT 19-22
Table 19-5
Leverage in valuing warrants

Low Stock Price High Stock Price

Stock price, $25; warrant price, $5* Stock price, $50; warrant price, $30
+$10 movement in stock price + $10 movement in stock price

New warrant price, $15 ($10 gain) New warrant price, $40 ($10 gain)

Percentage gain = $10 x 100 = 200% Percentage gain $10

= x 100 = 33%
in warrant $5 in warrant $30

*The warrant price would be greater than $5 because of the speculative premium.
Nevertheless, we use $5 for ease of computation.

© 2003 McGraw-Hill Ryerson Limited

 PPT 19-23

Use of Warrants in Corporate Finance

• May make a debt or preferred share issue more
attractive
• May be included as an add-on in a merger or
acquisition agreement
• Can be issued in a corporate reorganization or
bankruptcy to offer shareholders a chance to recover
some of their investment
• Traditionally has been associated with speculative
real estate companies, airlines, and conglomerates
• Popular with young companies, companies in
financial difficulties, chartered banks
© 2003 McGraw-Hill Ryerson Limited
 PPT 19-24

Review of Formulas (a)

1. Face value = Conversion price X Conversion ratio (19-1)

2. Fully diluted Adjusted aftertax earnings

earnings = (19-2)
per share Fully diluted shares

© 2003 McGraw-Hill Ryerson Limited

 PPT 19-25

Review of Formulas (b)

3. Intrinsic value of a warrant

I = (M — E)  N (19-3)
where
I = Intrinsic value of a warrant
M = Market value of a common stock
E = Exercise price of a warrant
N = Number of shares each warrant entitles
the holder to purchase

4. Speculative premium of a warrant

S = W — I (19-4)
where
S = Speculative premium
W = Warrant price
I = Intrinsic value

© 2003 McGraw-Hill Ryerson Limited


Summary and Conclusions
Derivatives include forwards,
futures, options, convertibles, and
warrants.
Forwards, futures and options
may be used to speculate on future
changes in the price of the
underlying assets, or may be used to
hedge (insure) an investment
transaction.
PPT 19-26
Convertibles are bonds or
preferred shares which may be
converted to common shares at the
option of the investor
Warrants are options to buy a
stated number of common shares at
a specified price.
Convertibles and warrants are
offered to make bonds or preferred
shares more attractive. They
increase in value as the common
shares appreciate
© 2003 McGraw-Hill Ryerson Limited