Chapter 3 Financial Instruments

1. Chapter 3Financial Instruments MGT 3412 Fall 2013 University of Lethbridge

2. Learning outcomes • Examine money market assets • Government Bonds • Companies’ Long Term borrowing loans/bonds • Corporate Bonds: fixed and floating rate; junk, callable, convertible etc. • Equity Financing –common/ preferred shares; rights, warrants. • Derivatives – futures, forwards, options (warrants) and swaps

3. Money Markets • Eurocurrency market and LIBOR • Bills • Repurchase agreements (repos)

4. Bond Markets • Government Bonds • Other Public sector securities • Corporate Bonds • Collateral • Sinking Fund • Protective Covenants • Callable, Convertible Bonds

5. Other Options LO5 • Call provision on a bond • Allows the company to repurchase the bond prior to maturity at a specified price that is generally higher than the face value • Increases the required yield on the bond – this is effectively how the company pays for the option • Put bond • Gives the bondholder the right to require the company to repurchase the bond prior to maturity at a fixed price

6. Convertible Bonds LO5 • Convertible bonds (or preferred stock) may be converted into a specified number of common shares at the option of the security holder • The conversion price is the effective price paid for the stock. It is the dollar amount of a bond’s par value that is exchangeable for one share of stock

7. Convertibles – continued LO5 • The conversion ratio is the number of shares received when the bond is converted • Conversion Premium – The difference between the conversion price and the current stock price divided by the current stock price • Straight Bond Value – The value of a convertible bond if it could not be converted into common stock

8. Convertibles – continued LO5 • Floor Value – Either the straight bond value or the conversion value • Convertible bonds will be worth at least as much as the straight bond value or the conversion value, whichever is greater

9. Minimum value of a convertible bond versus the value of the stock for a given interest rate LO5

10. Value of a convertible bond versus value of the stock for a given interest rate LO5

11. Valuing Convertibles LO5 • Suppose you have a 10% bond that pays semi-annual coupons and will mature in 15 years. The face value is $1,000 and the yield to maturity on similar bonds is 9%. The bond is also convertible with a conversion price of $100. The stock is currently selling for $110. What is the minimum price of the bond? • Straight bond value = 1081.44 • Conversion ratio = 1000/100 = 10 • Conversion value = 10*110 = 1100 • Minimum price = $1100

12. Equity Markets • Ordinary Shares • Preference Shares • Rights Issues

13. Warrants LO5 • A security that gives the holder the right to purchase shares of stock at a fixed price over a given period of time • It is basically a call option issued by corporations in conjunction with other securities to reduce the yield • Usually included with a new debt or preferred shares issue as a sweetener or equity kicker

14. Differences between warrants and traditional call options LO5 • Warrants are generally very long term • They are written by the company and exercise results in additional shares outstanding • The exercise price is paid to the company and generates cash for the firm • Warrants can be detached from the original securities and sold separately

15. Derivative Securities • Options • Warrants • Futures • Forwards • Swaps