MANAGERIAL FINANCE –BUS503
Professor : Rob Shah, MBA, CPA, CMA
Course Dates : 01/12 – 03/08
Name : NAVEEN XAVIER
European versus American options European options can be exercised only at expiry.
American options can be exercised at any time up to expiry. In-the-Money Exercising the option would result in a positive payoff. At-the-Money Exercising the option would result in a zero payoff (i.e., exercise price equal to spot price). Out-of-the-Money Exercising the option would result in a negative payoff
Call options gives the holder the right, but not the obligation, to buy a given quantity of some asset on or before some time in the future, at prices agreed upon today.
When exercising a call option, you “call in” the asset
Put options gives the holder the right, but not the obligation, to sell a given quantity of an asset on or before some time in the future, at prices agreed upon today. When exercising a put, you “put” the asset to someone.
Selling Options The seller (or writer) of an option has an obligation. The seller receives the option premium in exchange
Combinations of Options Puts and calls can serve as the building blocks for more complex option contracts. If you understand this, you can become a financial engineer, tailoring the risk-return profile to meet your client’s needs
Warrants Warrants are call options that give the holder the right, but not the obligation, to buy shares of common stock directly from a company at a fixed price for a given period of time. Warrants tend to have longer maturity periods than exchange traded options. Warrants are generally issued with privately placed bonds as an “equity kicker.” Warrants are also combined with new issues of common stock and preferred stock and/or given to investment bankers as compensation for underwriting services. In this case, they are often referred to as a Green Shoe Option
The Difference between Warrants and Call Options When a warrant is exercised, a firm must issue new shares of stock. This can have the effect of diluting the claims of existing shareholders.
Dilution Example Imagine that Mr. Armstrong and Mr. LeMond are shareholders in a firm whose only asset is 100 ounces of silver. When they incorporated, each man contributed 50 ounces of silver, then valued at $30 per ounce. They printed up two stock certificates and named the firm LegStrong, Inc.. Suppose that Mr. Armstrong decides to sell Mr. Mercx a call option issued on Mr. Armstrong’s share. The call gives Mr. Mercx the option to buy Mr. Armstong’s share for $1,500. If this call finishes in-the-money, Mr. Mercx will exercise, Mr. Armstrong will tender his share. Nothing will change for the firm except the names of the shareholders.
Dilution Example Suppose that Mr. Armstrong and Mr. LeMond meet as the board of directors of LegStrong. The board decides to sell Mr. Mercx a warrant. The warrant gives Mr. Mercx the option to buy one share for $1,500. Suppose the warrant finishes in-the-money, (silver increased to $35 per ounce). Mr. Mercx will exercise. The firm will print up one new share.
Convertible Bonds A convertible bond is similar to a bond with warrants. The most important difference is that a bond with warrants can be separated into different securities and a convertible bond cannot. Recall that the minimum (floor) value of a convertible is the maximum of: Straight or “intrinsic” bond value Conversion value The conversion option has value.
Litespeed, Inc., just issued a zero coupon convertible bond due in 10 years. The conversion ratio is 25 shares. The appropriate interest rate is 10%. The current stock price is $12 per share. Each convertible is trading at $400 in the market. What is the straight bond value? What is the conversion value? What is the option value of the bond?
Reasons for Issuing Warrants and Convertibles A reasonable place to start is to compare a hybrid like convertible debt to both