Chapter 3
Financial Instruments
MGT 3412
Fall 2013
University of Lethbridge
Learning outcomes
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Examine money market assets
Government Bonds
Companies’ Long Term borrowing loans/bonds
Corporate Bonds: fixed and floating rate; junk,
callable, convertible etc.
• Equity Financing –common/ preferred shares;
rights, warrants.
• Derivatives – futures, forwards, options
(warrants) and swaps
Money Markets
• Eurocurrency market and LIBOR
• Bills
• Repurchase agreements (repos)
Bond Markets
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Government Bonds
Other Public sector securities
Corporate Bonds
Collateral
Sinking Fund
Protective Covenants
Callable, Convertible Bonds
Other Options
LO5
• Call provision on a bond
– Allows the company to repurchase the bond prior
to maturity at a specified price that is generally
higher than the face value
– Increases the required yield on the bond – this is
effectively how the company pays for the option
• Put bond
– Gives the bondholder the right to require the
company to repurchase the bond prior to maturity
at a fixed price
LO5
Convertible Bonds
• Convertible bonds (or preferred stock) may be
converted into a specified number of common
shares at the option of the security holder
• The conversion price is the effective price paid
for the stock. It is the dollar amount of a
bond’s par value that is exchangeable for one
share of stock
25-6
LO5
Convertibles – continued
• The conversion ratio is the number of shares
received when the bond is converted
• Conversion Premium – The difference
between the conversion price and the current
stock price divided by the current stock price
• Straight Bond Value – The value of a
convertible bond if it could not be converted
into common stock
25-7
LO5
Convertibles – continued
• Floor Value – Either the straight bond value or
the conversion value
• Convertible bonds will be worth at least as
much as the straight bond value or the
conversion value, whichever is greater
25-8
LO5
Minimum value of a convertible bond versus the
value of the stock for a given interest rate
LO5
Value of a convertible bond versus
value of the stock for a given interest rate
25-10
Valuing Convertibles
LO5
• Suppose you have a 10% bond that pays semi-annual
coupons and will mature in 15 years. The face value
is $1,000 and the yield to maturity on similar bonds
is 9%. The bond is also convertible with a conversion
price of $100. The stock is currently selling for $110.
What is the minimum price of the bond?
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Straight bond value = 1081.44
Conversion ratio = 1000/100 = 10
Conversion value = 10*110 = 1100
Minimum price = $1100
Equity Markets
• Ordinary Shares
• Preference Shares
• Rights Issues
LO5
Warrants
• A security that gives the holder the right to
purchase shares of stock at a fixed price over a
given period of time
• It is basically a call option issued by
corporations in conjunction with other
securities to reduce the yield
• Usually included with a new debt or preferred
shares issue as a sweetener or equity kicker
25-13
LO5
Differences between warrants and
traditional call options
• Warrants are generally very long term
• They are written by the company and exercise
results in additional shares outstanding
• The exercise price is paid to the company and
generates cash for the firm
• Warrants can be detached from the original
securities and sold separately
25-14
Derivative Securities
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Options
Warrants
Futures
Forwards
Swaps