Chapter 3Financial Instruments

MGT 3412Fall 2013

University of Lethbridge

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

Money Markets

• Eurocurrency market and LIBOR• Bills• Repurchase agreements (repos)

Bond Markets

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

Other Options

• 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

LO5

25-6

Convertible Bonds

• 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

LO5

25-7

Convertibles – continued

• 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

LO5

25-8

Convertibles – continued

• 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

LO5

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

LO5

25-10

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

LO5

Valuing Convertibles

• 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

LO5

Equity Markets

• Ordinary Shares• Preference Shares• Rights Issues

25-13

Warrants

• 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

LO5

25-14

Differences between warrants and traditional call options

• 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

LO5

Derivative Securities

• Options• Warrants• Futures• Forwards• Swaps