2. Asset Classes: Equity and Equity Based Investments Flashcards
What two categories are equities divided into?
Ordinary shares
Preference shares
What is the performance of ordinary shares closely linked to?
- Fortunes/performance of the company
- this is typically associated with share price (doing well -> share price increases vv.)
Which shareholders face greatest risk and why?
Common stockholders/ ordinary shareholders
- only receive payout after all other claims from creditors, bondholders, pref. shareholders
- value of ordinary shares can decline if demand for shares declines
- maximum loss = 100% purchase price vs any commission paid
What is nominal value of a share?
minimum amount a company must receive from subscribers on issue of shares
When might a company not demand all nominal value of shares at issue?
Partly paid shares
What are redeemable shares?
Shares that can be bought back by company at its election (unusual)
What is the condition for companies to issue redeemable shares?
Non-redeemable shares must also be issue
What are shares without any voting rights called?
non-voting shares
What does issuing different classes of shares distinguish?
ownership and control
What do voting rights allow shareholders to do?
- vote at annual general meeting (AGM) and extraordinary general meetings (EGM)
What are the disadvantages of preference shares?
- often less liquid
- not actively monitored/easily purchasable by investors
- generally dont have voting rights
Why might pref shares underperform in a rising market compared to ordinary shares?
not actively monitored/easily purchasable by investors
When might a pref. shareholder become entitled to vote?
in the event of no dividend being paid for along time
- exact time period will be detailed in company constitution
Why are pref shares often referred to as hybrid securities?
Have both bond like and equity like characteristics
Bond like: fixed dividends
Equity like: they are shares
What is a cumulative pref share?
- shareholder is paid this years dividend before ordinary shareholder dividends
- also receives any unpaid dividends from previous years
What is a non-cumulative pref share?
Forfeit dividends not paid in previous period
What are participating pref shares?
- Can participate in additional distributions in event of liquidation
- entitled to money if there are additional funds leftover after all other pref shareholders are paid (as if they are also common stockholders)
What are convertible pref shares?
- shareholder has right (not obligation) to convert pref. share into predetermined number of ordinary shares
- eg. one pref share -> 2 ordinary shares
- this is another way of avoiding lack of potential upside compared to ordinary shares
what is a zero coupon and what is its upside?
pref share that pays no dividend
- shareholder redeems at a price above issue price
- eg buys from company at 10p per share and can redeem for 20p per share
Advantages of issuing shares?
- Company can raise capital
- Servicing varies with company performance
- Payments are discretionary
- Not obliged to redeem (unless its a particular type of shares that is to be redeemed)
Advantages of investing in shares?
- return linked to performance
- potential gain as well as income
- ownership rights
Disadvantages of issuing shares?
- sacrifice control (eg. due to activism)
- reputation
- potentially high payout
Disadvantage of investing in shares?
- Low ranking (risk capital)
- Potential volatility due to unrelated factors
What is the key drawback of pref shares?
When company generates large profit ordinary share dividend often rises but pref share dividend remains fixed
- participating pref shares and convertible shares created to combat this
What are the two main forms that depositary receipts come in?
- American depositary receipts (ADRs)
- Global depositary receipts (GDRs)
For what purpose were ADRs created?
To enable American investors to invest in overseas markets
Used by non-US companies in order to encourage US dollar investors to buy an equity stake
What are the pros and cons of ADRs for investors?
Pros:
- access to overseas companies (using domestic currency from domestic market)
- FX risk added to market risk
- Benefits may differ depending on terms of the DR
What are the pros and cons of issuing DRs?
Pros:
- raise capital internationally
Cons:
- lack of transparency on beneficial ownership (as they are bearer certificates) - don’t know who owns/has voting rights
What is the difference between ADRs and GDRs?
- GDRs are marketed to appeal to a broader base of investors (some of whom may be outside of the US)
- ADRS denominated in dollars whereas GDRs are usually denominated in dollars or euros
- ADRs are issued in the US but can be traded anywhere in the world
- GDRs are issued outside the US but can be traded anywhere in the world
Who typically creates (sponsors) DRs?
The foreign corporation
What is the process of a DR?
- foreign firm (issuer) creates/sponsors the DR
- issuer liases w investment bank regarding precise structure of the DR (eg. number/fraction of shares represented by each DR)
- Depositary bank accepts certain number of underlying shares from issuer
- DB then creates DRs to represent the shares and makes these DRs available to US and/or other investors (usually via local brokers - brokers local to the investors in the DRs)
- cash proceeds are then paid over to issuer
What is grey market trading?
- aka. pre-market trading
- This is the period whereby a DB may create and sell DRs when shares are not yet on deposit so long as the DB holds cash collateral
- At this point the investors are buying a receipt that entitles them to all the benefits of.a share that will be on deposit for the in the FUTURE
What is the time period for which a DB can sell the DR without yet having shares on deposit?
up to 3 months
In whose name are the underlying shares of a DR registered?
The DB
What is the process of a DR issuer issuing a dividend?
- company pays dividend in domestic currency to DB
- bank will then convert dividend into currency of investor (USD for ADRs) and pass it on to the DR holder
What is a key attraction of the ADR for US investors
- removal of need for any currency transactions
NOTE: this does not remove FX risk - investor takes on fx risk (not bank)
Do DRs have voting rights?
- DR holders are usually entitled to vote
- In some cases DRs are non-voting as a form of capital control (eg. NVDRs - non-voting depositary receipts in Thailand)
Who exercises a DR holders voting rights?
the DB
What is charged on the purchase of a DR instead of stamp duty and why?
DRs can be traded outside of the UK (in the Us for example) and therefore no stamp duty is charged on its purchase
Instead HMRC charges one off fee for stamp duty of 1.5% when the DR is created
What options does an investor have to sell their DRs?
- sell to another investor as a DR
- sell underlying shares in home market of company concerned
How does a DR holder sell the underlying shares of their DR?
- must first cancel the DR by delivering the certificates to the DB
- DB then releases appropriate number of shares
What proportion of shares is needed to maintain legal control of a company?
> 50% (must be more than)
What is share capital?
number of shares x nominal value
- does not actually show how much the company has raised through issuing shares
- simply a fixed accounting term
What is the nominal value of a share (and what is it not)?
- the fixed legal value of shares
- the number shown on the company’s BS
- not how much the shares are worth on the secondary market
What is authorised share capital?
Max. amount company can raise by issuing shares
What is issued share capital?
- number of shares that have been issued x nominal value of share
What is market capitalisation?
no. of shares in issue x share price
- since market cap is based on share price it can move up and down
What is free float adjusted market cap?
no of shares in the free float x share price
- this looks at shares freely trading between investors on the market
- excludes holdings by insiders eg. directors shares, shares held by pension funds (not freely available - long term investments)
What is the dividend of a preference share fixed against?
The nominal value of the shares (as a percentage)
Do preference shareholders have to be paid dividends?
No - dividends are always discretionary
What is a DR in simple terms?
A certificate that represents equity in an overseas company
Is a DR registered or bearer certificate?
Bearer - the person bears (or holds) the certificate has title to it - eg. banknotes
What is the issue when dividends for DRs are paid out?
As DRs are bearer certificates (which are anonymous) the bank doesn’t know who to pay dividends out to on dividend pay date
Therefore investors have responsibility to claim dividend from bank
ADRs vs GDRs
ADR
GDR
What is the difference between unsponsored DRs and sponsored DRs?
Unsponsored: DRs are simply bought by the bank off secondary market and they create DRs based on those shares without any discussion with the underlying company
Sponsored: Underlying company ‘sponsors’ the DRs - goes to bank to discuss issuing DRs
What is a warrant?
Right to subscribe for new shares from a company at a fixed price on a future date
- usually several years in advance
- future price often referred to as strike/exercise price
What are the options for issuing warrants?
- can be issued by company as a standalone
- can be issued as a sweetener with other investments (eg. corporate debt)
What are detachable vs non-detachable warrants?
Detachable - can separate warrant from bond and trade it separately
Non-detachable - cannot separate warrant from bond
Why do companies attach warrants to bonds?
- makes debt more attractive to investors therefore company can pay less interest on debt
Does issuing warrants increase share capital?
No - warrants are not part of ordinary share capital of company
They are the RIGHT to buy shares - not shares themselves
How do we calculate conversion premium on warrants?
conversion premium = warrant price + strike price - current share price
What does the conversion premium show us?
How much current share price needs to rise to make a profit by converting the warrant
It shows us the premium we technically pay by buying the warrant today (but we hope that current share price will increase such that when we do exercise the warrant we will not have paid a premium but instead bought at a discount)
What is a key benefit of warrants?
Investors can gain exposure to an asset at a fraction of the price = leverage which is why warrants are considered geared investments
What are the differences between warrants and covered warrants?
Issuer: warrants are issued by the company itself; covered warrants are issued by investment banks
Shares delivered: Warrants lead to new shares being issued (potential dilution); covered warrants are for existing shares (no dilution)
Maturity: Warrants usually >1year; Covered warrants usually <1year
Traded on: Warrants can be traded on a stock exchange (eg. LSE) or OTC; Covered warrants can only be traded on an exchange
Types: Warrants only give the right to buy the underlying share; Covered warrants allow the investor to buy and sell (call and put warrants)
Exercise/settlement: Warrants are physically settled contracts meaning they are settled by delivering the underlying shares; Covered warrants can be settled both physically and in cash
What does it mean for a covered warrant to be cash settled?
Investment bank looks at implied profit of warrant and pays investor in cash rather than issuing the underlying shares themselves
How are options different from covered warrants?
They are virtually the same except that they are issued by the writer (which can be anyone) and traded on derivatives exchanges
This is because covered warrants are considered securities and options are considered derivatives
What are covered warrants often referred to as?
Securitised derivatives
Why are covered warrants called such?
Because they must be ‘covered’ by the bank issuing them
This means that a bank issuing covered warrants must already hold the shares that the investor has the right to buy
This makes them safer than a standard option (hence securitised derivative)
What is are the key reasons covered warrants are safer than options?
- they are covered
- can only be issued by IBs (whereas options can be written by anyone)
What are the pros and cons of warrants for companies ?
Pros:
- can raise capital
- delays sacrificing control
- delays paying dividends
- makes other securities more attractive (eg. corporate bonds - lowers financing cost of debt)
Cons:
- On excercise:
- dilution of ownership
- issue equity below market price (potentially well below)
Why dies the exercise of warrants mean that a bank has to issue equity below market price?
Investors that have warrants will obviously only exercise if market price is higher than the strike price
What are the pros and cons of investing in warrants?
Pros:
- exposure to shares at a fraction of the price (gearing/lev)
Cons:
- no votes/dividends (it is not a share)
- potentially worthless if share price does not exceed strike price
