Convertibles, Warrants, and Derivatives
(Part D)
by
Charles Lamson
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Derivative Securities
There are many types of derivative securities but those that are most important for a basic understanding of the foundations of financial management are options and futures contracts. Derivative securities have value derived from an underlying security. In the case of equity options, the value is derived by the underlying common stock. Futures contracts on government bonds or Treasury bills derive their value from those government securities, and futures contracts on gold or wheat have those commodities as determinants of their basic values. The intent here is to present basic conceptual material that introduces you to derivative securities. Options Options give the owner the right, but not the obligation, to buy or sell an underlying security at a set price for a given period of time. Companies often reward their most valuable employees with stock options as part of their compensation. An employee stock option is very similar to a warrant, which was covered in the last post. An employee may be given an option to buy 10,000 shares of stock from the company at $25 per share. The employee stock option can have a life of 5 to 10 years and is supposed to motivate employees to focus on stockholder value. After all, if the stock goes to $100 per share over the life of the option, the employee could buy 10,000 shares of stock from the company for $250,000, sell the stock for $1,000,000 and pocket a taxable profit of $750,000. This is a phenomenon that has driven employee compensation for many companies. Employee stock options are worth understanding: you never know when you might get offered a bonus package consisting of an employee stock option. A call option is similar to an employee stock option in that it is an option to buy securities at a set price for a specific period of time, but it is usually traded between individual investors and not exercisable from the company. The Chicago Board Options Exchange is the foremost market for trading options. In a standardized call option, the writer of the call option guarantees that he or she will sell you 100 shares of stock at a set price. For this guarantee, the buyer of the call option pays the call writer a premium, perhaps $1 or $2 per share. If the option allows an investor to buy the stock at $40 per share and the stock closes at $38 on the expiration date, then the call writer keeps the premium and the call buyer loses his or her investment. On the other hand if the stock closes at $45 per share, the owner of the call has the right to pay the call writer $40 per share for the 100 shares and the writer must deliver the 100 shares. There are also other ways to close out the position at a profit that go beyond the scope of this discussion.  A put option is an option to sell securities to the option writer at a set price for a specific period of time. A put works just the opposite of a call. The put writer guarantees to buy the shares from you at a set price. The put buyer generally thinks that there is a probability that the underlying stock will fall in price and he or she wants to hedge the risk of a loss by giving the put writer a premium for the guarantee of transferring the stock at a set price. For example if the put owner has an option to "put" (sell) the stock at $80 per share, the option would only be exercised if the stock price was less than $80. If the stock went to $65, the owner of the put could sell 100 shares to the writer of the put for $80 per share ($8,000). A profit of $1,500 would be garnered. Puts are often used as hedges against falling security prices and the financial manager who is in charge of the corporate pension fund could use this tactic to ensure the pension portfolio from declining in value. Futures Futures contracts give the owner the right but not the obligation to buy or sell the underlying security or commodity at a future date. Futures contracts are very common for commodities and interest rate securities, especially government bonds. One characteristic of futures contracts is that the contract requires a very small down payment (margin) to control the futures contract. Often the down payment is 5 percent of the value of the underlying value of the securities or commodities. The major futures exchanges are the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME). Let us suppose that United Airlines was concerned that the price of oil might rise. Over the next 6 months it could buy futures contracts on oil to be delivered six months from now at a price of $25 per barrel. If the price were $35 per barrel 6 months from now, it would exercise its right to buy oil at $25 per barrel, or $10 cheaper, than the market price at that time. This is exactly what the German airline Lufthansa did during the fourth quarter of 2002: Lufthansa hedged against the rising price of oil by purchasing oil futures contracts during the first quarter of 2002, before oil prices mushroomed. The firm was able to mitigate the rising cost of fuel with the profits on its oil futures. A similar strategy could be used by Pillsbury or General Mills to lock in the price of the wheat they buy to make flower. Using futures contracts guarantees the price for both the farmer who might sell the futures contract and the manufacture who buys the futures contract. Futures contracts have varying time periods and the participants usually have monthly choices out to one year. With futures contracts you do not take physical possession of the item; the gains or losses are all settled on paper.  Other futures contracts that are commonly used to hedge corporate financial strategies are interest rate futures or foreign currency futures. One common financial futures strategy is to hedge against interest rate movements. Perhaps you are building a new plant and you intend to pay for the plant by borrowing money through a mortgage. In the short-term, the treasurer has negotiated a one-year construction loan at a floating rate. When the plant is complete, the treasurer will borrow the full amount from a mortgage banker on a 30-year loan and repay the construction loan. If interest rates go up during the next 12 months, the treasurer will pay more money for the loan. To hedge rising interest rates, the treasurer can use a financial futures contract to either lock in a rate or to profit from an increase in rates if rates go up, the treasurer can take the profit on the financial futures contract and use the profit to offset higher interest costs. Summary A number of security devices related to the debt and common stock of the firm are popular. Each security offers downside protection or upside potential, or a combination of these features. A convertible security is a bond or share of preferred stock that can be converted into common stock at the option of the holder. Thus the holder has a fixed income security that will not go below a minimum amount because of the interest or dividend payment feature and, at the same time, he or she has a security that is potentially convertible to common stock. If the common stock goes up in value, the convertible security will appreciate as well. From the corporate viewpoint, the firm may force conversion to common stock through a call feature and thus achieve a balanced capital structure. Interest rates on convertibles are usually lower than on straight debt issues.  A warrant is an option to buy a stated number of shares of stock at a specified price over a given time period. The warrant has a large potential for appreciation if the stock goes up in value. Warrants are used primarily as sweeteners for debt instruments or as add-ons in merger tender offers or bankruptcy proceedings. When warrants are exercised, as is the case for a convertible debenture. The potential dilutive effect of warrants and convertible securities must be considered in computing earnings per share. Derivative securities such as options and futures can be used to hedge risk such as the decline in the value of a pension fund portfolio, an oil price shock, an interest rate change, or a currency fluctuation. An option is the right, but not the obligation, to buy or sell a security at a set price for a fixed period of time. An employee stock option is one type of option contract and so are calls and puts. A call option is an option to buy while a put option is an option to sell. A futures contract is the agreement that provides for sale or purchase of a specific amount of a commodity or financial product at a designated time in the future at a given price. Review of Formulas   *MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 570-573* end |
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