1. 20 Financing with Derivatives ©2006 Thomson/South-Western

2. 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. 3 Classes of Derivatives Securities Options Futures and forwards Swaps

4. 4 Options exist in many forms S-T options on common stock Convertible fixed-income securities Warrants Rights Bonds with redemption provisions

5. 5 Option Exchanges http://www.aantix.com/ http://www.cboe.com/ http://www.cbot.com/ http://www.cme.com/

6. 6 Option Call Put buy Option to buy Option to sell Call and put options

7. 7 Call Option Valuation At expiration = Stock price – Exercise price Prior to expiration > Stock price – Exercise price Maximum value = Stock price Minimum value = 0

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9. 9 Variables Affecting Option Values Variablesaffecting the value of an option Time to expiration date Interest rates Expected stock price volatility Exercise price Stock price

10. 10 Convertible Securities Debentures and preferred stock 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.

11. 11 Reasons for Issuing Convertibles Make security more attractive Sell C/S in the future at higher price Allow time for investments to pay benefits Allows smaller, risky firms to acquire capital Reduces agency conflicts

12. 12 Valuation of convertibles 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

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14. 14 Option Valuation Calculator Check out the option valuation calculator at this Web site: http://www.numa.com/

15. 15 Conversion Voluntary Forced Call privilege Prior to expiration

16. 16 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

17. 17 Warrants (continued) 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

18. 18 Warrants (W) and Convertible Securities (C)

19. 19 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.

20. 20 Economic Value R = M o – S N + 1 Theoretical value of a right selling rights-on: R =R = M e – S N Theoretical value of a right detached:

21. 21 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)

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23. 23 Information on Swaps Check out the Chicago Board of Trade Web site as a source of information on swaps. http://www.cbt.com/