Right, Warrant and Option Chapter 11 Right, Warrant and Option

Learning Goals Understand what is Right offering and its characteristics How to value Right Understand what is Warrant and how to value warrant Understand what is Option and how to value option

Right and Its Characteristics An option that gives the existing shareholders an opportunity to acquire additional new share at a specified price (subscription or exercise price) over a specified short period of time Usually the specified price is set below the market price Option is valid only between 2 – 3 weeks. If it is not being used by that date, it will become worthless. Allow the existing shareholders to purchase only a fraction of the new share

The market Price of Shares after a Right Issue: The Theoretical Ex-Rights price When the rights are announced, the existing shareholders are entitled to the rights. The shares therefore are described as ‘cum-rights’ (with right attached) and will be traded ‘cum-rights’ After the new shares are being issued, the rights no longer exists and the shares are now ‘ex-rights’ (without right attached)

Value of a right Cum-right price = MP of shares - Subs. Price No. right + 1 = MP s - S N + 1 Ex-right price = (MP of x N) + Subs. Price common stock No. right + 1 = (MPs x N) + S

Advantages of Right It enables the existing shareholders to acquire additional shares without paying the normal brokerage fees Priority is given to the existing shareholders in acquiring the shares and subscription price (or exercise price) offered is below market price. Percentage of holdings will unaffected if the shareholders take up their rights

Disadvantages of Right The life of right is too short. Shareholders have to act fast or else they will lose the opportunity. The difference between the market price and subscription price (exercise price) is sometimes too narrow to allow for substantial profit. Shareholders must have sufficient cash available to take advantage of this opportunity.

Warrants or Transferable Subscription Right A long-lived option that gives the holder the right to buy fixed number of ordinary shares directly from the company at a specified price (subscription or exercise price) within a specified time period (before expiration date) No voting rights No claims on the company’s assets No dividends Life of warrant is longer compared to rights. It can range from 3 - 10 years or even 20 years or more and some do not have maturity at all

Normally attached to a corporation’s issue of senior security such as bond or preferred stock Attachment will make it possible for the investor to received fixed income return from interest of the bond or dividend of the preferred stock but also an opportunity to buy common share of the issuing company Usually detached from the accompanying securities and traded independently as separate securities. If the owner does not want to exercise the warrant, they can sell to other investors through Bursa Malaysia Stock Exchange. The non detachable warrant cannot be traded independently of the senior security.

An investors can invest in warrants in 2 ways Call the broker, inform them the warrants that you wish to buy, pay the normal brokerage commissions. If you look at the share prices in the business section of any local newspaper, you will find them listed together with the stocks buy identified with symbol ‘w’. When the price of the warrant is low, you will purchase them in anticipation of price increase in the future. The differential in purchase and selling price will be the profit after deduction the transaction cost or; Invest in warrants and exercise the warrant when the price of the shares in the market is high. This is especially true when you could purchase the shares from the company at a lower price and sells at the market for profit.

Two obvious features that differentiate warrants from rights are: Warrants are issued to holders of warrants which may not necessarily be the shareholders of the company. Warrant give right to purchase one whole new share or more whereas rights only allow purchasing a fraction of new share.

Features of Warrant Exercise price is the price that stated on the warrant and the amount an investor must pay to purchase the specific number of shares Conversion ratio is the number of common shares that can be obtained at the exercise price with one warrant. Expiration date is the day when the warrants are no longer having the privilege of buying common stock at specific price. Most warrant issued with the life span of 5 to 10 years. In Malaysia, most of the listed companies in the BMSE issue bonds with detachable warrants. Non-detachable warrants must be sold with the original securities to which they are attached.

Value of a Warrant Intrinsic = (Market price - Exercise price) x Exercise ratio Value of share of warrant = (MPs - EPw) x ER Speculative value/ = Market value of warrant - Theoretical value Premium value ($) Speculative value / = speculative value ($) Premium value (%) Theoretical value

Some of the speculative factors that will affect the premium include: Remaining warrant life. The smaller the remaining life of a warrant, the less valuable it becomes. This is because the opportunity to make profit declines.   Price volatility of the share. The more volatile is price of the shares, the more chance the value of the warrant appreciates above the theoretical or intrinsic value. Investor will be more willing to pay a larger premium for such a warrant. The leverage Potential of Warrant. Warrant offered investors a cheaper way to invest because the purchase of a number of warrants is always cheaper than the purchase of a corresponding number of ordinary shares.

Advantages of Warrant Warrants have a tendency to behave like the common stock to which they would be converted into Warrants are cheaper than the common stocks The low capital investment of warrants has lower downside risk than the underlying stock.

Disadvantages of Warrant To invest in warrants, one must be knowledgeable about the exercise price and expiration date for conversion It pays no dividend therefore investors do not get current income It carries an expiration date.

Options 2 types of options Call option a negotiable instrument that gives the holder (buyer) the right to buy the underlying security at a specified price over a set period of time from the seller/maker/writer in exchange for a fee paid to the seller/maker/writer The buyer of the call option wants the price of the underlying assets to go up The seller/maker/writer of the call option wants the price of the underlying assets to go down Covered call: seller owns the asset Naked call: seller does not own the asset

Buy shares at RM20 x 200 shares = 4,000 Calculation: The call option of Syarikat AG stock has a strike price of RM20 and a cost of option RM2 per share with one month expiration date. The current market price of the share is RM16. If you buy 2 lots of shares, calculate the profits or losses at the expiration date if the price is RM 30. (1 lot = 100 unit of share)  Buy shares at RM20 x 200 shares = 4,000 Cost of option RM 2 x 200 shares = 400 Total cost = 4,400   Sell shares at RM30 x 200 shares = 6,000 Profit 1,600

Profit /loss = [(SP – MP) x No. of share] – cost of call = RM 1,600

Put option a negotiable instrument that enables the holder (buyer) to sell the underlying security at a specified price over a set period of time to the seller/maker/writer in exchange for a fee paid to the seller/maker/writer The buyer of the put option wants the price of the underlying assets to go down The seller/maker/writer of the put option wants the price of the underlying assets to go up

Sell shares at RM12 per share x 300 = 3, 600 Less: Calculation The cost of the put option for Syarikat Gemilang is RM150 per lot. The striking price is RM12. You wish to sell 3 lots. The market price of the share is RM15. Determine your profit or loss if you exercise the option at 1 lot for RM7.00 per share and at 2 lots for RM8.00 per share. Sell shares at RM12 per share x 300 = 3, 600 Less: Cost of Option RM150 per lot x 3 lots = 450 Gross profit = 3, 150  Buy shares at RM7.00 per share x 100 shares = 700 Buy shares at RM8.00 per share x 200 shares = 1600 Profit = 850

Profit/loss = [(SP-MP) x No. of share] – cost of put = RM 350 = [(12-8) x 200] – 300 = RM 500 Profit = RM350 + RM500 = RM850