1. © 2004 by Nelson, a division of Thomson Canada Limited Contemporary Financial Management Chapter 17: Managing Domestic Risk

2. © 2004 by Nelson, a division of Thomson Canada Limited 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

3. © 2004 by Nelson, a division of Thomson Canada Limited 3 Derivative Securities  As the name implies, all derivative securities derive their price from some underlying asset  Derivative securities provide a mechanism whereby companies can: Lay-off risk they don’t want Assume additional risk, with the expectation of earning a return

4. © 2004 by Nelson, a division of Thomson Canada Limited 4 Basic Types of Derivatives  Options  Futures and forwards  Swaps

5. © 2004 by Nelson, a division of Thomson Canada Limited 5 Types of Option-like Securities  Calls and puts  Convertible fixed-income securities  Warrants  Bond refunding  Rights offering

6. © 2004 by Nelson, a division of Thomson Canada Limited 6 Types of Options Call Option Right to buy an asset at a known price for a fixed period of time Put Option Right to sell an asset at a known price for a fixed period of time

7. © 2004 by Nelson, a division of Thomson Canada Limited 7 Important Option Features  The cost to purchase an option is known as the premium, which the buyer must pay up front.  All options must be sold or exercised prior to their expiry date, or they become worthless.  The price at which the asset is bought/sold under the option contract is the exercise price.  To the buyer, the option represents the right, not the obligation to undergo an action.  The option writer (or seller) has an obligation to perform if the buyer decides to exercise option.

8. © 2004 by Nelson, a division of Thomson Canada Limited 8 Call Option Exercise  To exercise a call option, the buyer must pay to the writer of the option the exercise price  In return, the writer must deliver to the buyer the underlying asset (such as a common stock)

9. © 2004 by Nelson, a division of Thomson Canada Limited 9 Put Option Exercise  To exercise a put option, the buyer must deliver to the writer the underlying asset (such as a common stock)  In return, the writer must pay to the buyer the exercise price

10. © 2004 by Nelson, a division of Thomson Canada Limited 10 Variables Affecting Option Value Variables affecting the value of an option Stock Price Expiration Date Price Volatility Interest Rates Exercise Price

11. © 2004 by Nelson, a division of Thomson Canada Limited 11 Variables Affecting Option Value Increase to Variable:Effect on Call Option Prices Effect on Put Option Prices Share Price ↑↓ Exercise Price ↓↑ Volatility ↑↑ Risk-free interest rate ↑↓ Expiration date ↑↑

12. © 2004 by Nelson, a division of Thomson Canada Limited 12 Call Option Valuation  Call option value (C) equals the greater of: Share price (S) – Exercise price (X) Zero In compact notation, C=max{S-X, 0}  Maximum possible value at expiration: Share price  Minimum value at all times Zero

13. © 2004 by Nelson, a division of Thomson Canada Limited 13 Call Option: Min, Max & Market Values Max. Option Value: Stock Price Min. Option Value: Option Value on Expiration Date Market price prior to Expiration Date Exercise Price Share Price Call Option Value

14. © 2004 by Nelson, a division of Thomson Canada Limited 14 Convertible Securities  A convertible security is convertible into common stock, usually at the option of the holder  Conversion ratio Number of shares obtained in conversion  Conversion premium Conversion price is usually greater than stock’s market price when convertible is issued

15. © 2004 by Nelson, a division of Thomson Canada Limited 15 Reasons for Issuing Convertibles  Make security more attractive – buyer can participate in the company’s success but with less risk than buying equity today  Sell common shares in the future at a price greater than today’s market price  Allow time for investments to generate value  Makes owning securities in small, risky companies more attractive Lessens the agency conflict between bond holders and shareholders

16. © 2004 by Nelson, a division of Thomson Canada Limited 16 Valuation of Convertibles  Conversion value Conversion ratio times the share price  Investment value Equals the straight bond value  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

17. © 2004 by Nelson, a division of Thomson Canada Limited 17 Valuation of Convertibles Share Price Value Conversion Value Bond or Investment Value Market Price

18. © 2004 by Nelson, a division of Thomson Canada Limited 18 Conversion Voluntary (Prior to expiration) Forced (Call Privilege)

19. © 2004 by Nelson, a division of Thomson Canada Limited 19 Warrants  Allows the holder to purchase additional common shares for some period of time at a fixed exercise price  Usually issued as a sweetener attached to other securities  Exercise price Price at which common stock may be purchased Usually 10% to 35% above the market price when the warrants are issued

20. © 2004 by Nelson, a division of Thomson Canada Limited 20 Warrants  Expiration date Date when the option to purchase ends 5–10 years  Usually trade separately from the underlying security  Provide leverage to investors (similar to a long- dated call option)  Market value of warrant Usually exceeds the difference between the stock price and exercise price (its intrinsic value) The difference is called the time value premium

21. © 2004 by Nelson, a division of Thomson Canada Limited 21 Warrants  On the expiry date, the value of the warrant is equal to its intrinsic value, which is:  Prior to the expiry date, the warrant trades above this price. The longer the time before expiry and the greater the volatility of the price of the common stock, the greater the premium above intrinsic value.

22. © 2004 by Nelson, a division of Thomson Canada Limited 22 Warrants vs. Convertible Securities Characteristic W C Lessen Agency Conflicts x x Deferred Issuance of Common Shares x x Savings of Interest or Dividends x x Company Receives Additional Funds x Two Securities on Books x More Control x

23. © 2004 by Nelson, a division of Thomson Canada Limited 23 Rights Offering  An offer to sell new equity to a firm’s existing shareholders.  Each shareholder can acquire new shares in an equal proportion to their current ownership.  Formally known as the Preemptive Right. If firm’s charter contains a Preemptive Right clause, the firm must first offer to sell any new equity to existing shareholders

24. © 2004 by Nelson, a division of Thomson Canada Limited 24 Rights Offering  One right is issued for each share owned  To acquire a new share, holder must submit the subscription price plus X rights  Subscription price set below current market price at time of issue (or the holder would not have an incentive to exercise the right)  Rights are issued attached to the common stock. Stock initially trades rights-on or cum-rights.  When rights trade separate from the common stock, the stock is said to trade ex-rights.

25. © 2004 by Nelson, a division of Thomson Canada Limited 25 Rights Offering Example: The Miller Company has 10 million shares outstanding, which currently trade at $40. It plans to sell 1 million new shares via a rights offering, with a subscription price of $35. In this case, each right entitles the holder to purchase 0.1 new shares. Thus it takes 10 rights plus $35 to purchase one new share.

26. © 2004 by Nelson, a division of Thomson Canada Limited 26 Valuation of Rights Theoretical Value: Selling Rights-on Theoretical Value: Selling ex-Rights M 0 = Rights-on market price of share M e = Ex-rights market price of share S = Subscription price N = Number of rights needed for share purchase

27. © 2004 by Nelson, a division of Thomson Canada Limited 27 Rights  A shareholder must either exercise or sell their rights, prior to the expiry date, or she will lose a portion of her wealth  Since a right is very similar to a short call option, its market value will typically be somewhat above its theoretical value prior to the expiry date.  It will trade at its theoretical value on the expiry date

28. © 2004 by Nelson, a division of Thomson Canada Limited 28 Swaps  A swap is a contractual agreement between two parties to make periodic payments to each other  Two major types of swaps Interest rate swaps Currency swaps  Interest rate swaps allow a firm to either reduce or increase interest rate risk (the risk arising from a change in interest rates)

29. © 2004 by Nelson, a division of Thomson Canada Limited 29 Interest Rate Swaps: Typical Use  Company has a fixed rate asset and a floating rate liability. It is exposed to the risk that interest rates might rise.  To reduce risk, company may enter into a swap whereby it exchanges its floating rate liability for a fixed rate liability, thereby reducing interest rate risk

30. © 2004 by Nelson, a division of Thomson Canada Limited 30 Interest Rate Swaps: Example  Company A has a fixed rate bond with a 10% coupon. It wants to swap this fixed rate liability for a floating rate liability.  Company B has a floating rate bond on which it pays LIBOR plus 1%. It wants to exchange this floating rate liability for a fixed rate liability.  A bank acts as a mediary to help Company A and Company B arrange a swap.

31. © 2004 by Nelson, a division of Thomson Canada Limited 31 Interest Rate Swaps: Illustration 10% Fixed Rate Bond Floating Rate Bond (LIBOR + 1% ) Company A Bank Company B LIBOR Fixed Rate Fixed Rate Partial Offset Partial Offset

32. © 2004 by Nelson, a division of Thomson Canada Limited 32 Major Points  The price of all derivative securities is derived from the price of some underlying asset.  Options give the holder the right but not the obligation to undertake some action.  Options exist in many forms, such as call & puts, warrants, rights and convertible securities.  Swaps allow companies to exchange cash flows to reduce (or assume) risk.