Rights and Warrants

14 Pages   |   3,245 Words
Table of Contents
Introduction: 2
Literature Review: 3
Options: 4
Call Option: 4
Put Option: 4
Strike Price: 4
Subscription Price: 4
Intrinsic Price: 4
Right Price: 5
Time Value: 5
Discussion: 5
Conclusions: 12
References: 13
 

Introduction:

Investors these days, because of economic condition and rise in risk level, prefer to invest in mutual funds, as they are more secure investments and have mediate risk. Investors expect gain from mutual funds, so their preference for investment diverts towards these funds. As the maturity level increase, investors start to divert their attention to trading of individual securities. Where, investors face and deal with the options rights and warrants.
A warrant is primarily a certificate that allows its holder to buy a certain amount of a bond or preferred share at a fixed price; a price usually above current market price. Duration of a warrant can vary from a few years to a to its life time. Securities act help as a sweetener to attract investment and get money for the operations. When price of security increases more than its exercise price, it will allow the holder to buy the warrant at its exercise price and can sell if for a profit. If the price of warrant never increases the warrant will not be exercised, and it will expire. Warrants usually got listed on options exchanges and traded independently of security (Investor Words n.d.)

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On the other hand, rights issuance occurs when company wants to raise money these rights will allow the shareholder to buy the company’s shares directly from the company at a price lower than the market value or market price of outstanding shares.  Rising of the funds is helpful for raising more money and is favourable to the existing shareholders.
Usually, both the warrants and rights serve the purpose to raise money, so, their purpose is the same. However, difference exists in the timing or expiration of these securities. Warrants have a large life span, and they can extend from several years to life span. While, rights have a shorter lifespan, these expire after few weeks (Rights and Warrants: Are They Right for You? 2003).

Literature Review:

It is necessary to consider few essential terms that appears quite frequently and are pivotal in derivatives and securities. Various studies have been conducted in order determine the extent to which individuals may derive benefits through warrants and rights issuance. The preferences of people may differ substantially due to various reasons.
In his study, Harvey (2012) explains the importance of rights which are granted to shareholders which enables them to get either old or new shares of common stock which have already been issued. According to the author, people who are interested in short term investment should opt for these shares. Apart from having a short duration, it is also easy to transfer these shares from one person to the other.
On the other hand, Kinahan (2012) conducted a study, favouring options as being the most suitable kind of investment. The author explains that despite the high probability of risk involved, if the person is able to gain returns through this investment, the amount of the returns would be magnified when compared with other type of less risky investments. Therefore, people who are risk-loving in nature should choose the option contract which allows them to sell any underlying asset before its date of expiration at a certain pre-decided price.
Campbell describes Rights as the privileges that got granted to shareholders to get or buy newly issued shares of common stock. These shares got presented to shareholders before they got offered to public. These rights have a shorter lifespan of two to four weeks and are freely transferable (Harvey 2012).

Options:

Options are a contract, which provides its holder the right to sell an underlying asset at a specified price till its expiration. Investors need to be careful in dealing with options as they are involving high risk and return factors (Kinahan 2012).

Call Option:

A call option provides its holder the right to buy an underlining asset at some future date and at a price which both parties agree upon before.

Put Option:

A put option provides its share holder with rights to sell an underlining asset at some future date and an agreed upon price (Call­ and Put ­Options n.d.).
Bemis (2006) used various mathematical examples to explain the Put and Call option parities which exist when comparing these options and analyzing the disparities which exist between those of American and European options. According to the author, despite the generally accepted definitions of both Put and Call options, there are different ways through which they are calculated, implying the space available for differences that may be faced when they are being calculated. However, according to the author, regardless of the differences available, the main features of the call and put options remain the same. A call option allows two parties to buy any asset at a future date whereas the put option gives right to two parties to sell the asset according to a specific price at a future date.

Scott (2003) focuses on the point that one of the most crucial factors which determine the main decision of an investor apart from the probable returns that they are expected to get is the price that they have to face for any investment. The different types of prices which investors mostly have to face before buying or selling of any stock includes a strike price (exercise price), subscription price i.e. a price at which, the holder of rights can buy shares in new issuance, intrinsic price which is the difference between the stock price and the subscription price and Right price which is the summation of time value and intrinsic value of that right. The value of stocks may also be affected by the expiration date and their value tends to decrease with the arrival of this expiry date.

Strike Price:

An agreed upon price on which an underlining asset or a security can be purchased (for a call option) or sold (for a put option). Strike price as the exercise price can be used vice versa (Investopedia n.d.).

Subscription Price:

It is a price at which, the holder of rights can buy shares in new issuance. This price is mostly lower than the market price, reason being to make it attractive for the investor (Scott 2003).

Intrinsic Price:

It is simply a difference between the stock price and subscription price.

Right Price:

It is just summation of time value and intrinsic value of that right.

Time Value:

Time value can be defined as a value gained through exposure to fluctuations and moments in an underlying security. Usually, with the expiration date gets closer, the time value decreases.
Wasiliev, terms warrants as forms of derivatives, deriving their value from any underlining instrument. Some of these warrants give its holder the right to buy and whereas some give them an option to sell the underlining instrument to the issuer. While some warrants entitles holders to receive payments as per the value of underlying instruments. The author signifies the advantages of warrants by stating that theyWarrants serve as multipurpose and can be attached and issued with securities, communities, or share basket etc. Because of such flexibilities risk varies, warrants can have a high risk and return or even lower risk and return profiles. (Wasiliev n.d.)
Shrewin presents a different view of these securities. Sherwin and argues, that if one looks at an investors’ perceptive, securities are just used to leverage the profit with rise in stock price. Rights, Call option and Warrants fall in same category. Difference in these exist form an issuer point of view, where rights are short term issued directly by the company. While other securities like Call options are issued by option writers (Help Globe 2008).

Discussion:

As per above discussion, it can be clearly concluded that the main purpose of rights and warrants is to attract investment. On the other side for it, for an investor, it is an opportunity and attraction because of their leverage potential. When company seeks fund, it issues securities lower thenthan the market rate to ensure stock holders purchase a pro Rata share. These securities provide them with privileges or pre-emptive rights to acquire additional shares at a lower price. The document that provides shareholder’s the pre-emptive rights, known as rights. These rights save the shareholders from dilution form the value of his holding in the company. When new shares got issued, their amount of issuance is calculated by determining the amount of funds, that the company aims to raise and dividing the total funds by the amount that shareholders must pay to subscribe to them. For example, let’s take an assumption of a firm that has 10,000 shares outstanding having a market price of $10. From this one can say that the total markets value of that the firm is $100,000. Now let’s assume that the firm decides to sell $40,000 of the new stock with the rights and determines the subscription price to be $8. The company needs to issue 5000 new shares. The new price of the shares excluding rights will be $9.33 (McGowan and Heil n.d.). Other part of it determines the number of rights to needed to buy shares. In above examples, 2 rights would be needed to by each new share this can be calculated as:
Number of rights needed= Number of rights guaranteed/ Number of new issued shares
= 10000/5000= 2 rights per new share
If one needs to determine the value of these rights, these can be done through calculations of the overall equity that can be calculated by:
Total value of equity = Equity’s value prior to issuance + amount to be raised
= (shares outstanding * price) + amount to be raised
= (10,000*$10) +$40,000
=$140,000
New price for shares can be determined as follows:
New price of shares = Total value of equity / Total shares outstanding
= ($100,000+$40,000)/ (10,000+5000)
= $9.33
Lastly, one has to determine the value of the right itself. There are few methods described, but here the right price or its value would be calculated as follows:
Right price = (old price of outstanding shares – market price) / (number of rights per share + 1)
= ($10-$8) / (2+1)
=$0.67
Now let’s see how these rights work, before the new offerings the market value of 10 shares was $100(10* $10). Let’s assume that the shareholder has 10 old and 5 new shares, worth 140(9.33*15). If the shareholder decides not to exercise his 10 rights and sell in instead.
Shareholder will still have $100 in his hands. Shareholder’s 10 old shares will now be worth 93.3 and his 10 rights for 5 new shares would be worth 6.7(0.67*10).
Right offerings provided the investor with the flexibility, to maintain his ownership in the company as per percentage of shares or sell that ownership. Whenever a company issues stocks, it issues at a discount price, to attract the investors and get more money for operations. At the same time, the existing stockholders’ has worthy rights. It depends on the individual basis and values whether he sells the shares or keep the rights and invest in new shares. The investor is free to choose any of the option (McAllister 2003). Rights act as a security to protect investor from devaluation of shares if the company goes around for financing.
Although these are short term securities and allow provides investors with an opportunity to buy stock for a short period, these are still quite popular successful in rising finds. These securities are quote beneficial for the investors because they can purchase shares without incurring the cost like broker fee and also at low price. In Aaddition to that, they provide an opportunity to make money it the stock price increases. However, McGowan argues that small investors will not have enough rights to purchase whole shares of sell them to get economical benefits. On the other hand, the large investors will find such practice to be detrimental, reason being; new investments will be too substantial (McGowan and Heil n.d.).
Apart from the benefits received through rights offerings, one cannot ignore the significant advantages received by those who invest their money in warrants. The Iintrinsic value of a warrant  or a right come into play, when the market value of the underlying asset rises above its exercise price One can say, that vale of  these securities is almost same as the difference in exercise price and market price. Its normal for the price of rights are warrants to fall in the secondary market in congruency with the fluctuation of underlining asset. There can be four possibilities with rights and warrants within these fluctuations, and they are:
  • Exercise all or some of these securities.
  • Sell all or some of these securities.
  • Buy additional securities.
  • Do nothing and let these securities expire.
As discussed before, leverage is the main reason the investors get attracted towards warrants. These warrants are usually with a preferred stock or a bond. Let’s now consider the reasons for attraction towards warrants.
Let’s assume there warrants that have exercise value of $10 trading at $3, while, the trading value of common stock is $12. As expiry dates approaches, this is what happens.
 
  Share price falls to $9 Share price falls to $10 Share price remains at $15 Share price rises to
$23
Warrant price $0 $0 $2 $13
Intrinsic value $0 $0 $2 $13
Time value $0 $0 $0 $0
Stock $ gain (Loss) ($3) ($2) $0 $11
Stock % gain (Loss) (25%) (17%) 0% 91%
Warrant $ gain (Loss) (3) (3) ($1) $10
Warrant % gain (Loss) (100%) (100%) (33%) (333%)
 
 
Above table represents the changes that occur when the expiration date approaches. If, an investor is dealing with the trading of shares, these prices fluctuation will expose investor to relatively small losses, of 25% or 17%, and if stock prices increase to a certain amount, 23 in this case, they will leverage investor’s profit to 91%. On the other hand, if the investor is dealing in warrants. He is exposing himself to relatively higher losses of 100% or 33%. On the other side of it, if the price of shares rises it is a golden pot for the investor as these provide much higher leverage, 333% in the above case. One can conclude that, these securities got laid with a basic principle of risk and reward. Higher the risk investor take higher is the reward for him. However, investors obviously take calculated risks.
Usually warrants have many characteristics as that of a call option. Like, trading happens in the secondary market, have same in providing rights as that of an equity option. However, there can be many of differences to be notified.
Warrants, instead of a public exchange, are private parties’ issue. Addition to that, there are differences when both got exercised. With exercising of a warrant, the number of outstanding shares increases, because the company issue new shares. While, when a call option exercises the option holder receives existing shares from the underwriter. Warrants are over-the –counter securities, so these securities are primarily helps in settling transactions by the financial institutes. Life span of the warrant is much longer then a call option its lifespan is usually in years. While, call options have much shorter lifespan, its lifespan is usually in months. Warrants are just a piece of paper upon expiration. Lastly, warrants don't get listed on like exchange listed options, in other words, they are not standardized.
Generally, warrants serve as an incentive for an investor to accept bond or preferred shares. These offerings serve are usually attractive, but their attractiveness is congruent to the growth of the company. Campbell says that company attaches warrants to other securities, to increase the marketability of the underlined securities (Harvey 2012). When a warrant got issued it gets the issue with a higher market value than that of underlining asset. These are usually long term while perpetual securities can last forever (The Free Dictionary n.d.).
Because of difference in the purpose of each warrant, warrants should be studied carefully. As, with each of its offering, each warrants can be used differently to gain different advantages so, one should carefully observe their workings. Wasilieve identifies different types and purpose of warrants that include Structure Investment Products, Trading Warrants, Endowments, Barrier Warrants and Instalments. Instalment warrants provides direct exposure to underlining assets through initial payments. While, endowments are usually 10 years warrants, promoted as investments held till expiry, whereas structured investments serve as a package to meet financial targets. (Wasiliev n.d.). 
Let’s assume there warrants that have exercise value of $10 trading at $3, while, the trading value of common stock is $12. As expiry dates approaches, this is what happens.
 
  Share price falls to $9 Share price falls to $10 Share price remains at $15 Share price rises to
$23
Warrant price $0 $0 $2 $13
Intrinsic value $0 $0 $2 $13
Time value $0 $0 $0 $0
Stock $ gain (Loss) ($3) ($2) $0 $11
Stock % gain (Loss) (25%) (17%) 0% 91%
Warrant $ gain (Loss) (3) (3) ($1) $10
Warrant % gain (Loss) (100%) (100%) (33%) (333%)
 
 
Above table represents the changes that occur when the expiration date approaches. If, an investor is dealing with the trading of shares, these price fluctuations will expose investor to relatively small losses, of 25% or 17%, and if stock prices increase to a certain amount, 23 in this case, they will leverage investor’s profit to 91%. On the other hand, if the investor is dealing in warrants. He or she is exposing themselves to relatively higher losses of 100% or 33%. On the other side of it, if the price of shares rises it is a golden pot for the investor as these provide much higher leverage, 333% in the above case. One can conclude that, these securities got laid with a basic principle of risk and reward. Higher the risk investor take higher is the reward for him. However, investors obviously take calculated risks.
In order to calculate the value of a warrant, it is important to note that there are two distinct components of warrants. On one hand, it can be said that the:
The warrant price = time value + intrinsic value of warrant
Where the time value is as follows:
Time value = warrant price – intrinsic value
        = (warrant price + exercise price) – share price
It is crucial to note that the exercise price is inflexible thus any increase in the price would lead to high returns by increase in the intrinsic value. Most of the time, investors are willing to exploit the return that they are expected to get in the remaining life of a warrant and thus they pay the premium which is associated with it (Incademy 2012).
There can be several disadvantages of rights and warrants issuance. Warrants gear up fast, at the same time plummet causing a substantial risk. Addition to that, they are much more complex then shares and are potential to put investors off. Warrants’ issue size is quite small, causing lower turnover and difficulty in handling. Warrant holders usually have no medium of income like reception of dividends. The rights of warrant holders are quite specific they don't have rights to vote nor attend AGMs. If there is a hostile takeover, then the warrants become worthless as the warrant holders are a force to exercise warrants at an intrinsic value of zero. Upon exercising of the warrants, the shares or underlining asset dilutes with the issuance of new shares. Lastly, the warrants are prone to less information. These lack listing, so it is quite hard to find the proper information and mediate risk (Incadamy Investor Education n.d.)
On the other hand, there are some question marks associated with rights. Rights cause an increase in the dilution in value of the shares as their number will increase. It does serve a weapon to get balance sheet right, but it is not a permanent solution for the previous causes of weakening of the balance sheet. These are attractive for the invertors, but they are values this way that many a times, investors do not get bargain (Case 2008).

Conclusions:

Rights and warrants raise funds for the issuer, but they never serve as a permanent solution. These should be temporary, and one should carefully look into the reasons for the weakening of the balance sheet. Rights issue with common stocks whiles the warrant with either stock or a bond, in other words, an underlining asset. These rights and warrants have leverage as their main attraction. Having them issued, they have potential to increase investor’s income by many folds. Especially warrants have that the ability to leverage income by many folds. However, these securities follow the principle of risk and rewards.
The more investor is willing to take risk the more one will be getting reward. These types of the securities are primarily used to raise funds but, there are some differences among them. Like, rights have a shorter lifespan while warrants lifespan is in years, even life time. Many of time a warrant mingles up with a call option, but there are certain differences in them. These types of securities are extraordinarily complex, and as a result, there are few disadvantages attached to them. Though these securities are quite attractive, but carefully evaluated and mostly result in no income of their holder.
Special people called hawks are specialized in taking advantage of such offerings. For an issuer point of view, these offerings should be taken as saver of last resort. They do raise funds but should not be considered for permanent. Whether, they should focus on the reasons for the problems and should focus in strengthening the balance sheet through its operations.
 

References:

"Call­ and Put ­Options." 1-6.
Case, Andrew. "Rights Issues: Is the Time Right?" Small Cap Opinion, 2008: 4.
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Incadamy Investor Education. http://www.incademy.com/courses/Traditional-corporate-equity-warrants/Disadvantages-of-warrants/6/1068/10002 (accessed Nov 24, 2012).
Investopedia. http://www.investopedia.com/terms/e/exerciseprice.asp#axzz2D4bLTLBu (accessed Nov 23, 2012).
Investor Words. http://www.investorwords.com/5285/warrant.html (accessed Nov 22, 2012).
Kinahan, J. "The Trick or Treat of Trading Options." Forbes, 2012: 5.
McAllister, Thomas J. " McAllister Financial Planning." Wall Street Words, 2003.
McGowan, Carl B, and Karl Heil. "Rights (Securities)." Reference for Business 5.
"Rights and Warrants: Are They Right for You?" CSI Global Education Inc, 2003: 2.
Scott, David L. "An A to Z Guide to Investment Terms for Today's Investor." Wall Street Words, 2003: 1.
The Free Dictionary. http://financial-dictionary.thefreedictionary.com/warrants (accessed Nov 22, 2012).
Wasiliev, John. "Warrants, Understanding Trading and Investment Warrants." Australian Securities Exchange 42.

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