Exchange Traded Derivatives

Question 1

What is a convertible?

Answer 1

A fixed income security which gives the holder the right but not the obligation to convert into a predetermined number of shares for a premium.

Question 2

What are the two ways in which a convertible can be priced:

Answer 2

1) Dividend Valuation model
2) Crossover Method

Question 3

What is the dividend valuation model?

Answer 3

Calculate the future price of the stock

Discount this as the redemption value and discount coupons as normal

Question 4

What is the crossover method?

Answer 4

Calculate at which point the discounted dividend payments are greater than the coupon.

Sum together the coupons received and add the the price of equity * number of shares which can be converted in to.

Question 5

Why are these methods not accurate for convertibles?

Answer 5

Because convertibles should be thought as a low coupon bond and an option or warrant

Question 6

Since a convertible can be thought as an option - what can determine its price?

Option pricing factors

Answer 6

1) Exercise price
2) Underlying price
3) Time to expiry
4) Interest Rates
5) Whether the share pays a dividend
6) Volatility expectations

Question 7

What is the exercise price of an option?

Answer 7

The lost proceeds from holding the debt (e.g. the principal £100)

Question 8

How do you calculate conversion price?

Answer 8

Market Price / Number of shares that can be converted into

Question 9

What is a warrant?

Answer 9

It entitles the holder to buy a certain number of shares for a set price during a set period.

Like a call option but will dilute existing holdings

Question 10

What are the advantages of warrants to the issuer?

Answer 10

1) Raise capital - without having to increase dividend payments
2) Increases attratctiveness of debt (equity sweetener)
3) Lower yields on debt (cheaper for issuer)
4) Warrants are detachable and can be traded
5) If share price falls - saved money & wan’t have to issue new shares

Question 11

What are the disadvantages of warrants to the issuer?

Answer 11

1) Issue equity at a significant discount
2) Dividend payments may dramatically increase

Question 12

What are the advantages of warrants to the holder?

Answer 12

1) Cheaper than buying the shares directly
2) Secures income yield whilest keeping access to available equity performance

Question 13

What are the disadvantages of warrants to the holder?

Answer 13

1) Geared investment - loss can be extreme is share price underperforms
2) Risk of takeover - expiry date will be accelerated and warrant will lose all time value

Question 14

What is the premium on a warrant?

Answer 14

The premium is the excess paid for a share through a warrant (compared to market price)

Question 15

How is the gearing of a warrant defined?

Answer 15

How much exposure an investor has to the underlying compared to exposure they would have if they buy through the market.

Question 16

How established is the secondary market for warrants?

Answer 16

1) Some issuer are able to list warrants on an exchange
2) Many though are privately held / not registered (makes the price unclear)
3) Some secondary markets do exist which provide liquidity

Question 17

What are the differences between warrants and call options?

Answer 17

1) Warrants run for years - options run for months
2) Warrants are dillutive
3) Warrants are issued by private parties - options are issued by exchanges
4) Warrants are not standardised - options standardise # of shares per contract

Question 18

What drives the value of a warrant?

Answer 18

1) Its time value
2) Price of underlying

Question 19

How is the conversion premium of a warrant calculated?

Answer 19

Price of warrant + Exercise Price - spot price of underlying

Question 20

How are warrants valued - why does this differ from options?

Answer 20

Warrant Value = A / 1+ Q

A = Value of equivalent optoin
Q = Percentage increase in shares