TOPIC: Warrants & Convertible

Introduction of the topic:-

Warrants:-

A warrant, like an option, gives the holder the right but not the obligation to buy an
underlying security at a certain price, quantity and future time.

Companies will often include warrants as part of a new-issue offering to entice

investors into buying the new security. A warrant can also increase a shareholder's
confidence in a stock, if the underlying value of the security actually does increase
overtime.

A certificate, usually issued along with a bond or preferred stock, entitling the
holder to buy a specific amount of securities at a specific price,

A derivative security that gives the holder the right to purchase securities (usually
equity) from the issuer at a specific price within a certain time frame.

A security entitling the holder to buy a proportionate amount of stock at some

specified future date at a specified price, usually one higher than current market price.
Warrants are traded as securities whose price reflects the value of the underlying stock.
Corporations often bundle warrants with another class of security to enhance the
marketability of the other class. Warrants are like call options, but with much longer time
spans-sometimes years. And, warrants are offered by corporations, while exchange-
traded call options are not issued by firms.

A security, that permits its owner to purchase a specific number of shares of stock
at a predetermined price.

For example:-

A warrant may give an investor the right to purchase 5 shares of XYZ common
stock at a price of $25 per share until October 1, 2007. Warrants usually originate as part
of a new bond issue, but they trade separately after issuance. Warrants usually have
limited lives. Their values are considerably more volatile than the values of the underlying
stock.

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Convertible bond:-

A convertible bond (convertible) is a bond that can be exchanged for shares on or

before maturity.

A bond that can be converted into a predetermined amount of the company's equity
at certain times during its life, usually at the discretion of the bondholder.

A convertible bond gives its owner the option to exchange the bond for a
predetermined number of shares. the convertible bondholder hopes that the issuing
company's share price will zoom up so that the bond can be converted at a big profit. but if
the shares zoom down, there is no obligation to convert the bond holder remains a
bondholder.

Explanation:-
Convertibles give bond holders a hedge against the risks arising from agency
issues. If a company follows a risky strategy that increases the value of shares but
decreases that of debt then holders of convertibles can choose to convert.

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Important Sub Topics:-

There are different types of warrants:-

A call warrant and a put warrant. A call warrant represents a specific number of
shares that can be purchased from the issuer at a specific price, on or before a certain
date. A put warrant represents a certain amount of equity that can be sold back to the
issuer at a specified price, on or before a stated date.

Warrants can either be detachable or no detachable. Detachable warrants may be

sold separately from the bond which it is associated. Has, the holder may exercise the
warrant but not redeem the bond if he or she wishes. A no detachable warrants are sold
with its bond to be exercised by the bond owner simultaneously with the convertible bond.

Characteristics of a Warrant:-
Warrant certificates have stated particulars regarding the investment tool they
represent. All warrants have a specified expiry date, the last day the rights of a warrant
can be executed. Warrants are classified by their exercise style: an American warrant, for
instance, can be exercised anytime before or on the stated expiry date, and a European
warrant, on the other hand, can be carried out only on the day of expiration.

The underlying instrument the warrant represents is also stated on warrant certificates.
A warrant typically corresponds to a specific number of shares, but it can also represent a
commodity, index or a currency.

The exercise or strike price is the amount that must be paid in order to either buy the
call warrant or sell the put warrant. The payment of the strike price results in a transfer of
the specified amount of the underlying instrument.

The conversion ratio is the number of warrants needed in order to buy (or sell) one
investment tool. Therefore, if the conversion ratio to buy stock XYZ is 3:1, this means that
the holder needs three warrants in order to purchase one share. Usually, if the conversion
ratio is high, the price of the share will be low, and vice versa.

Investing In Warrants:-
Warrants are transferable, quoted certificates, and they tend to be more attractive
for medium-term to long-term investment schemes. Tending to be high risk, high return
investment tools that remain largely unexploited in investment strategies, warrants are
also an attractive option for speculators and hedgers. Transparency is high and warrants
offer a viable option for private investors as well. This is because the cost of a warrant is
commonly low, and the initial investment needed to command a large amount of equity is
actually quite small.
Convertible versus warrants:-

The difference between convertible and warrants are as follow.

1. Exercising convertibles does not generally provide additional funds to the firm,

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 while exercise of warrants does.
2. When conversion takes place the debt ratio is reduced, however, the exercise of
Warrants adds to the equity position with debt still remaining.
3. Due to the call feature, the company has greater control over the timing of the
Capital structure with convertible than with warrants.

Should you issue straight or convertible bond:-

Companies often issue securities that give the owner an option to convert them into
other securities. These options may have a substantial effete on value. The most
dramatics example is provided by warrants, which are nothing but an option, the owner of
a warrant can purchase a set number of the company's shares at a set price before a set
date. Warrants and bonds are often sold together as a package.

Conversion Ratio:-
The conversion ratio (also called the conversion premium) determines how many
shares can be converted from each bond. This can be expressed as a ratio or as the
conversion price, and is specified in the indenture along with other provisions.

Example
A conversion ratio of 45:1 means one bond (with a $1,000 par
value) can be exchanged for 45 shares of stock. Or it could be
specified at a 50% premium, meaning if the investor chooses
to convert their shares they have to pay the price of the
common stock at the time of issuance plus 50%. Basically,
these are the same thing said two different ways.

This chart shows the performance of a convertible bond as the stock price rises.
Notice that the price of the bond begins to rise as the stock price approaches the
conversion price. At this point your convertible performs similarly to a stock option. As the
stock price moves up or becomes extremely volatile, so does your bond.

It is important to remember that convertible bonds closely follow the underling’s

price. The exception occurs when the share price goes down substantially. In this case, at
the time of the bond's maturity, bond holders would receive no less than the par value.

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Review Of theoretical & practical Situation:-

Why do companies issue warrants?

Instead of issuing a convertible bond, companies sometime sell a package of

warrants. Warrants are simply long term call option that gives the investor the right to buy
the firm's common stock. An issue of warrants contains a straight bond and option.

Warrants do not have to be issued in conjunction with other securities. Often they
are used to compensate investment bankers for underwriting services. many companies
also give their executives long term option to buy stock. These executives stock option
are not usually called warrants, but that is exactly what they are companies can also sell
warrants on their own directly to investors, through they rarely do so.

Through warrants additional funds are received by the issuer, when a bond is
issued with warrants, the warrants price is typically set between 10% and 20% above the
stock's market price. if the company’s stock price goes above the option price, the
warrants will, of course, he exercised at the option price. the closer the warrants are to
their expiration date, the greater the chance is that they will be exercised.

The simple answer is that warrants are issued by companies to raise money
options

 Warrants expire at a pre-determined date

 Warrants are based on an underlying asset such as stocks
Buyer of a warrant must pay a price (or premium) up front
 Warrants can only be exercised at a pre-determined price or strike price
 When the underlying asset of the warrants is trading below the strike price of
the warrant then the price of the warrant is generally based on time or
volatility.
 Warrants are exercised your profit is the difference between the strike price
and the market price. Obviously you won't exercise you warrant if the price
you can exercise them at is above the market price.

Why do companies issue convertibles?

You are approached by an investment banker who is anxious to persuade you that
your company should issue a convertible bond with a conversion price set some what
above the current stock price. She points out that investor would be prepared to accept a
lower yield on the convertible, so that it is "cheaper" debt that a straight bond. you observe
that your company's stock perform as well as you expect, investor will convert the bond
"Great “she replies " in that case you will have sold shares at a much better price than you
could sell them for today. It’s a win-win opportunity.

Is the investment banker right? Are convertible "cheap debt”? of course not. They
are a package of e straight bond and a option. the higher price that investors are prepared
to pay for the convertible represents the value that they place on the option. The
convertible is cheap only if this price overvalues the option.

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 What then of the other arguments. That,= the issue represents a deferred sale of
common stock at an attractive price. The convertible gives investors the right to buy the
stock by giving up a bond. Bond holders may decide to do this, but then again they may
not. Thus issue of a convertible bond may amount to a deferred stock issue. But if the firm
needs equity capital, a convertible issue an unreliable way of getting it.

A survey of companies that had seriously considered issuing convertible found in

58% of the case management considered convertibles an inexpensive way to issue
"delayed" common stock. % of the firm’s viewed convertible as less expensive than
straight debt. Taken at their face value, these arguments don't make sense. but we
suspect that these phrases encapsulate some more complex and rational motives.

Notice that convertible tend to be issued by the smaller and more speculative firms.
They are almost invariable unsecured and generally subordinated. now put your self in the
position of a potential investor. you are approached by a firm with an untried product line
that wants to issue some junior unsecured debt. you know if thing go well. You will get
back your money, but if they do not, you could easily be left with nothing. Since the firm is
in a new line of business, it is difficult to assess the chance of trouble. Therefore you don’t
know what the fair rate of interest is, also you may be worried that once you have made
the loan, management will be tempted to run extra risks. it may take on additional senior
debt, or it may decide to expect its operations and go for broke on your money. in fact,. if
you charge a very high rate of interest, you could be encouraging this to happen.

What can management can do to protect you against a wrong estimate of the risk
and to assure that its intentions are honorable. ion crude terms, its can give you a price of
the action. You don't mind the company runs nine unanticipated risks as long as you share
in the gains as well as losses. Convertible securities make sense. Whenever is is
unusually costly to assess the risk of debt or whenever investors are worried that
management may not act in the bondholder interest.

The relatively low coupon rate on convertible bonds may also be a convenience for
rapidly growing firms facing heavy capital expenditures. They may be willing to provide the
conversion option to reduce immediate cash requirement for debt service. without that
option, lender might demand extremely high interest rate to compensate for the probability
of default. this would not only force the firm to raise still more capital for debt services but
also increase the risk of financial distress. Paradoxically, lender attempt to protect them
against default may actually increase the probability of financial distress by increasing the
burden of debt service on the firm.

Convertible bonds tend to be issued by smaller, more speculative firms that find it
difficult, because of risks inherent in their operations, to sell straight bonds or common
stock at a reasonable cost. More often than not, convertible bonds represent the result of
an effort to obtain financing that is not easily obtained in any other way. Prosperous
companies generally do not finance their growth with new securities. They do their
financing with internally generated profits. If internally generated funds are not adequate,
companies will resort to straight, non-convertible debt, if possible. That is because they do
not want to dilute their shareholders' equity. The convertible feature is tacked on to a bond
as a "sweetener" when a straight, non-convertible issue would seem so risky to potential
investors that the interest rate that would have to be paid to sell the bond would be
exorbitant. The conversion feature makes the bond more readily marketable. In short,
convertible bonds are usually issued by companies that are not doing particularly well, to
help them get over their difficulties. Convertible bonds, too, are typically subordinate

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debentures which mean that their standing, in the event of default, is lower than that of
any other of the company's debt or even its bank loans.

Issuing convertible bonds is one way for a company to minimize negative investor
interpretation of its corporate actions. For example, if an already public company chooses
to issue stock, the market usually interprets this as a sign that the company's share price
is somewhat overvalued. To avoid this negative impression, the company may choose to
issue convertible bonds, which bondholders will likely convert to equity anyway should the
company continue to do well.

From the investor's perspective, a convertible bond has a value-added component

built into it; it is essentially a bond with a stock option hidden inside. Thus, it tends to offer
a lower rate of return in exchange for the value of the option to trade the bond into stock.
Lower rate of return in exchange for the value of the option to trade the bond into stock.

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Merits & de- merits with respect to topic:-
Merits of warrants:-

The merits of issuing warrants include the following

1. They allow for balanced financing between debt & equity.

2. They permit the issuance of debt at a low interest rate.

3. They serve as a sweetener for an issue of debt or preferred stock

Let us look at an example that illustrates one of the potential benefits of warrants.
Say that XYZ shares are currently priced on the market for $1.50 per share. In order to
purchase 1,000 shares, an investor would need $1,500. However, if the investor opted to
buy a warrant (representing one share) that was going for $0.50 per warrant, with the
same $1,500, he or she would be in possession of 3,000 shares instead!

Because the prices of warrants are low, the leverage and gearing they offer is high.
This means that there is a potential for larger capital gains and losses. While it is common
for both a share price and a warrant price to move in parallel (in absolute terms) the
percentage gain (or loss), will be significantly varied because of the initial difference in
price. Warrants generally exaggerate share price movements in terms of percentage
change.

Let us look at another example to illustrate these points. Say that share XYZ gains
$0.30 per share from $1.50, to close at $1.80. The percentage gain would be 20%.
However, with a $0.30 gain in the warrant, from $0.50 to $0.80, the percentage gain would
be 60%.

Warrants can offer significant gains to an investor during a bull market. They can
also offer some protection to an investor during a bear market. This is because as the
price of an underlying share begins to drop, the warrant may not realize as much loss
because the price, in relation to the actual share, is already low.

De- merits of warrants:-

The de- merits of issuing warrants include the following

1. When exercised they will result in dilution of common stock

2. They may be exercised at a time when the business has no need for additional
capital.

Like any other type of investment, warrants also have their drawbacks and risks. As
mentioned above, the leverage and gearing warrants offer can be high. But these can also
work to the disadvantage of the investor. If we reverse the outcome of the example from
above and realize a drop in absolute price by $0.30, the percentage loss for the share
price would be 20%, while the loss on the warrant would be 60%!

Another disadvantage and risk to the warrant investor is that the value of the
certificate can drop to zero. If that were to happen before it is exercised, the warrant would

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lose any redemption value.

Merits of convertible bond:-

To the company, the advantages of convertible bond issuance are

1. It serves as sweetener in a debt offering by giving the investor an opportunity to

take part in the price appreciation of common stock. by selling common stock at
a gain if held for more than 6 month the stockholder will receive a favor able tax
treatment in the form of a capital gain deduction.

2. The issuance of convertible debt allows for a lower interest rate on the financing
relative by issuing straight debt.

3. A convertible bond may be issued in a right money market, when its difficult for
a credit worthy firm to issue a straight bond or proffered stock.

4. There are fewer financing restriction involved with a convertible bond issuance.

5. Convertible provide a mean is issuing equity at prices higher than present

market prices.

6. The call provision enables the firm to force conversion whenever the market
price of the stock is greater than the conversion price.

De-merits of convertible bond:-

To the company, the disadvantages of convertible bond issuance are

1. If the company stock's price appreciably increases in value. it would have been
better off financing through a regular issuance of common stock by waiting to
issue it at the higher price instead of allowing conversion at the lower price.

2. The company is obligated to pay convertible debt if the stock price does not
increase.
Conclusion:-
Finally, a holder of a warrant does not have any voting, shareholding or dividend
rights. The investor can therefore have no say in the functioning of the company, even
though he or she is affected by any decisions made.
Warrants can offer a smart addition to an investor's portfolio, but due to their
risky nature, warrant investors need to be attentive to market movements. This largely
unused investment alternative, however, can offer the small investor the opportunity for
diversity without having to compete with large, market-influencing institutions.

Getting caught up in all the details and intricacies of convertible bonds can make
them appear more complex then they really are. At their most basic, convertibles provide
a sort of security blanket for investors wishing to participate in the growth of a particular
company they’re unsure of. By investing in converts you are limiting your downside risk at
the expense of limiting your upside potential.