1. ©2009 McGraw-Hill Ryerson Limited 1 of 32 19 Derivative Securities Prepared by: Michel Paquet SAIT Polytechnic ©2009 McGraw-Hill Ryerson Limited

2. 2 of 32 Chapter 19 - Outline Derivatives Forwards Futures Use of Derivatives: Risk Reduction Options Use of Derivatives: Financing Convertible Securities and Warrants Summary and Conclusions

3. ©2009 McGraw-Hill Ryerson Limited 3 of 32 Learning Objectives 1.Distinguish between and outline the uses of forwards, futures and options. (LO1) 2.Calculate the hedge on futures and the value of call and put options. (LO2) 3.Describe the securities offered by a corporation that are convertible into common shares at the option of the investor and are a means of raising funds. (LO3) 4.Outline the benefits of a convertible security, including a fixed rate of return and the potential for capital appreciation. (LO4)

4. ©2009 McGraw-Hill Ryerson Limited 4 of 32 Learning Objectives 5.Calculate the conversion value of a convertible security. (LO5) 6.Describe warrants and compare them to convertible securities. (LO6) 7.Calculate the intrinsic value and the speculative premium on a warrant. (LO7) 8.Demonstrate how convertible securities and warrants affect earnings per share as reported on the income statement. (LO8)

5. ©2009 McGraw-Hill Ryerson Limited 5 of 32 Derivatives also called derivatives securities, are contracts giving the holder the right to buy or sell an asset at a set price, at some time in the future assets underlying derivatives include commodities, foreign exchange, interest futures, stocks, etc. the value of these contracts is “derived” from the underlying asset derivatives include forwards, futures and options derivatives can be used for speculating and risk reduction purposes LO1

6. ©2009 McGraw-Hill Ryerson Limited 6 of 32 Forwards the most basic derivatives are customized contracts fixing the price of the underlying asset and fixing the delivery place and date no payment is due until the future agreed-upon date the two parties negotiate face-to-face the most common underlying assets are foreign exchange and interest rate. LO1

7. ©2009 McGraw-Hill Ryerson Limited 7 of 32 Futures similar to forwards, futures contracts fix the price of the underlying asset for future delivery however, futures are standardized contracts and traded on financial markets futures contracts are available only in set amounts or multiples and only for certain months commodities, interest rates, market indexes and currencies can be covered by futures LO1

8. ©2009 McGraw-Hill Ryerson Limited 8 of 32 Use of Derivatives: Risk Reduction Both forwards and futures can be used to remove a large portion of the uncertainty surrounding a future transaction through fixing the price. LO1

9. ©2009 McGraw-Hill Ryerson Limited 9 of 32 An Illustration of a Forward Contract By entering into this forward contract, the farmer has the responsibility to deliver 500,000 bushels of corn and in return will receive US$1,145,000 regardless of the price of corn at the time of delivery. LO1

10. ©2009 McGraw-Hill Ryerson Limited 10 of 32 An Illustration of a Futures Contract LO2

11. ©2009 McGraw-Hill Ryerson Limited 11 of 32 Options 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 at a preset price 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 LO2

12. ©2009 McGraw-Hill Ryerson Limited 12 of 32 Options vs. Futures Similarity Both have a limited life, are standardized and are guaranteed by the market acting as a clearinghouse Differences Options require a larger up-front payment Futures require a small margin deposit being credited or debited daily Major Difference An option contract may expire as the holder has a right not an obligation Both parties to a futures contract are obliged by the contract LO2

13. ©2009 McGraw-Hill Ryerson Limited 13 of 32 Call option (assuming price of underlying share rises) LO2

14. ©2009 McGraw-Hill Ryerson Limited 14 of 32 Call option (assuming price of underlying share falls) LO2

15. ©2009 McGraw-Hill Ryerson Limited 15 of 32 Speculative premium Price of common stock Intrinsic value (minimum value) of option 40 12 24 36 48 60 72 Market value (premium) of option Value of option ($) 30 20 10 0 -10 -20 Figure 19-1 Market price relationships for a call option LO2

16. ©2009 McGraw-Hill Ryerson Limited 16 of 32 Put option (assuming price of underlying share rises) LO2

17. ©2009 McGraw-Hill Ryerson Limited 17 of 32 Put option (assuming price of underlying share falls) LO2

18. ©2009 McGraw-Hill Ryerson Limited 18 of 32 Figure 19-2 Market price relationships for a put option 5427 Price of common share Premium (market value of option) Intrinsic (minimum) value of option 27 Speculative premium Value of option ($) LO2

19. ©2009 McGraw-Hill Ryerson Limited 19 of 32 Use of Derivatives: Financing Corporations issue option-like securities to raise capital These 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 the 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 LO3

20. ©2009 McGraw-Hill Ryerson Limited 20 of 32 Convertible Securities a type of hybrid securities combining features of debt and common equity –a bond or share of preferred stock that 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 LO3

21. ©2009 McGraw-Hill Ryerson Limited 21 of 32 Terminology Conversion Ratio: –number of shares of common stock into which the security may be converted Conversion Price: –price at which the security can be converted into common stock; equals face (par) value of bond / conversion ratio Conversion Value : –conversion ratio x market price of common stock Conversion Premium: –difference between the market value of the security and the conversion value LO3

22. ©2009 McGraw-Hill Ryerson Limited 22 of 32 Advantages and Disadvantages 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) LO3

23. ©2009 McGraw-Hill Ryerson Limited 23 of 32 Pure bond value $785.18 Price of common stock ($) Conversion value 10 20 30 40 50 60 70 Market price of convertible bond Bond values ($) Premium Figure 19-3 Price movement pattern for a convertible bond 200 400 600 800 1000 1200 1400 LO5

24. ©2009 McGraw-Hill Ryerson Limited 24 of 32 Yield to Maturity on Issue, Coupon, Conversion Market Yield toBonds of Similar Risk and MaturityRating Value Value Maturityand Maturity George Weston 3% June 2023BBB (high) $1,603.17 $1,628.80n.a. 6.55% Noranda 5% April 2007 BBB(low) 869.39 995.00 5.195.36 Telus 6.75% June 2010 BBB 507.78 1,028.80 6.16 6.20 Pricing of Convertible Debentures, July 2004 LO5

25. ©2009 McGraw-Hill Ryerson Limited 25 of 32 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 warrants 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 LO6

26. ©2009 McGraw-Hill Ryerson Limited 26 of 32 Table 19-2 Relationships determining warrant prices, October 2008 LO6 Source: www.tsx.com; www.financialpost.com/markets/market_data/group-warrants.html.www.tsx.com

27. ©2009 McGraw-Hill Ryerson Limited 27 of 32 Speculative premium Price of common stock Intrinsic value of warrant 40 10 20 30 40 50 60 Market value of warrant Value of warrant ($) 30 20 10 0 -10 -20 Figure 19-4 Market price relationships for a warrant LO6

28. ©2009 McGraw-Hill Ryerson Limited 28 of 32 Table 19-3 Leverage in valuing warrants Low Stock PriceHigh 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 Percentage gain $10 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. = x 100 = 200%= x 100 = 33% LO6

29. ©2009 McGraw-Hill Ryerson Limited 29 of 32 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 LO6

30. ©2009 McGraw-Hill Ryerson Limited 30 of 32 Review of Formulas (a) 1. Face value = Conversion price X Conversion ratio (19-1) 2. DilutedAdjusted aftertax earnings earnings = (19-2) per share Shares outstanding + shares from Conversion LO6

31. ©2009 McGraw-Hill Ryerson Limited 31 of 32 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 LO6

32. ©2009 McGraw-Hill Ryerson Limited 32 of 32 Summary and Conclusions Derivatives are contracts fixing the price of the underlying asset for future delivery. Derivatives include forwards, futures and options. While forwards are customized contracts, futures are standardized. Options give the holders a right while forwards and futures oblige both parties. Corporations use derivatives for risk reduction and financing purposes. Rights, convertible securities and warrants are option- like securities issued by corporations to raise capital.