Chapter
20
Financing with Derivatives
Copyright ©2003 South-Western/Thomson Learning
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.
Classes of Derivatives: Securities
• Options
• Futures and forwards
• Swaps
Options
• S-T options
• Convertible fixed-income
securities
• Warrants
• Bond refunding
• Rights offering
Option Exchanges
• http://www.aantix.com/
• http://www.cboe.com/
• http://www.cbot.com/
• http://www.cme.com/
Options to Buy and Sell
Call
Option to buy
Option
Put
Option to sell
Call Option Valuation
• At expiration = Stock price – Exercise
price
• Prior to expiration > Stock price –
Exercise price
• Maximum value = Stock price
• Minimum value = 0
Variables Affecting Value
Exercise price
Stock price
Variables
affecting
the value of
an option
Time to
expiration date
Interest
rates
Expected stock
price volatility
Convertible Securities
• Debentures and PS
• 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.
Reasons for Issuing Convertibles
• Make security more attractive
• Sell C/S in the future at higher price
• Allow time for investments to pay
benefits
• Small, risky companies
• Lessen agency conflict
Valuation
• 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
Option Valuation Calculator
• Check out the option valuation
calculator at this Web site:
http://www.numa.com/
Conversion
Voluntary
Prior to expiration
Conversion
Forced
Call privilege
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
Warrants (cont.)
• 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
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 Additional
Funds
Two Securities on Books
More Control
x
o
x
o
o
x
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.
Economic Value
Theoretical value of a right selling rights-on:
Mo – S
R=
N+1
Theoretical value of a right detached:
R=
Me – S
N
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)
Information on Swaps
• Check out the Chicago Board of Trade
Web site as a source of information on
swaps.
http://www.cbt.com/