 Hello and welcome to the session. This is Professor Farhad in which we would look at option-like securities such as callable bond, convertible securities, warrants, as well as other securities. These topics are covered on the CPA exam as well as the CFA exam and an essential or principle of investment course. As always, I'm going to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1800 plus accounting, auditing, tax, finance, as well as Excel tutorials. If you like my lectures, please like them and share them. If they benefit you, it means they might benefit other people. Connect with me on Instagram and Facebook. On my website, farhadlectures.com, you will find additional resources to complement and supplement this course as well as your other accounting and finance courses. I strongly suggest you check out the website. Starting with callable bond, it's a form of option-like securities. Now, what are option-like securities? Option-like securities are financial instruments and arrangement that have features that convey some sort of an either implicit or explicit option to one or more parties. Those are option-like. They are not specifically options, but the agreement somehow, like for example, we're going to see in callable bond, convertible bond warrant, as well as other securities. They give one of the holder options to do things, and that's why we call them option-like securities, starting with callable bond. So, for example, when corporate bond are issued with a call provision entitling the issuer. So, it's very important to understand who has the option. When we use the term callable, who has the option? The company, the firm, or the issuer. It means the company that issued the bond will have the right to call it back. Call means buy it, buy it back, to buy the bond back from the bond holder at a specified call price. Now, you might be asking, why would the company do so? Just the first thing, why would the company wants to buy back their own bond? Well, one reason is when they borrowed the money, they needed the money. And at some point in the future, they find out that now they have enough cash flow, so why keep paying interest if we don't need to? Or they issued the bond at 10%. And at that point, their credit rating was triple B. Now, their credit rating is double B. Now, they can issue the same bond for 8%. So, they will call back the old bond, issue the new bond. So, that's basically some of the reasons why the companies would do something like this. Why will they call back or will have a call provision? Now, the company can always buy back their bond. But the risk is, what if the bond went up a lot in price? Then it's going to be cost prohibitive for them to buy it. So, if they include the call provision, then they can buy it at a specified price. Now, well, the natural question is why would bonds go up in price? Why would bonds go up in price? Bonds go up with price because interest rate went down. Interest rate are lower. When interest rate is lower, bonds will go up. So, if you have a bond that's paying 8% and now interest rate is 6% for similar bond, this bond, it's going to go up in value because it's paying 8%. So, that's why the company will be like, well, hold on a second. Now, we can't buy the bond because it's cost prohibitive. But if we can, we can issue it at 6%. So, simply what's happening, the holder of the bond is simply taking a risk of that bond being taken away from them. Okay? So, the exercise price is the price at which the bond can be repurchased. So, they always tell you what the exercise price is and bond are issued as a percentage of the power. For example, if they tell you the price is 105, it means they'll pay you 105% of the face value. They'll pay 5% more than the face value. So, essentially, this type of bonds is a combination of a straight bond held by the investor. So, the investor has a straight bond. However, the company has a call option held by the bond issuing firm, by the company. Well, investor, they must receive a compensation for that option. If I am selling you an option, I want to be compensated for that option because I am giving you this option to buy the back bond from me. If the callable were issued with the same coupon rate as the straight bond, we would expect them to sell at a discount to the straight bond. Of course, if I am going to lend you money, and let's assume there are two bonds. One is a straight bond, let's call it SB, and one is a callable bond. They cannot be of the same price. For you to entice me to buy this callable bond, you either have to lower the interest rate. So, if this bond is paying 10%, the callable bond will have to pay 12% or 13%. So, you have to pay me more of interest rate or if this bond is selling at a thousand, I am only going to pay you 9.50 for this bond, a discounted amount. Otherwise, why would I pay you the same amount for a straight bond if I am buying a callable bond? I am giving you the option for something. Don't make me pay a thousand dollars, give it to me at a discount or increase my interest rate or a combination of the two. So, in other words, callable bond, they have to pay higher interest or they will be sell at a discount. To sell a callable bond at par, firms must issue them with a coupon rate higher than those of the straight debt. And hopefully this makes sense to you. I am not, as a lender, as a buyer of the bond, you know you're giving them a feature, an extra feature. Well, they have to pay for their extra feature by compensating you with higher interest or coupon payment or interest payment. The higher coupon are investors' compensation for the option retained by the firm. So, basically, you have to compensate me. And what happened is the callable features are defined in the initial bond covenant, in the bond agreement. And it all depends on the need of the issuing firm and its perception of the market taste. So, when they sell those callable bond, they determine it's basically, it's a contract between the lender and the holder. And you just have to read the contract to see what the risks you are taking. It could be they cannot buy it until five years from now or 10 years from now, so on and so forth. And this graph kind of shows us what the value of the straight debt, the value of the straight debt could go up. Why would the value of the straight debt could go up the bond? Again, the main reason is interest will go down. So, we can kind of call this why access is the interest. But this is unusual why access because the lower the interest, the lower the interest, the higher the value of the debt, the higher the lower the interest, the lower the interest. So, if this is the lower the interest, so if this is 11, 10, 9, the lower the interest rate, the higher value of the debt. So, what happened is, so if the company wants doesn't want the debt to go up a lot, but they want to retire the debt, what they do is they do a callable price. So, once they have a callable price and the debt value will, you know, they'll pay a certain price for that debt. Once it falls, once there's an interest rate is reached, and they'll pay back the bond. Convertible securities are option like securities, but those they give the holder, not the company, the right to convert their bond or their preferred stock. Who sells convertible securities like Tesla and one of these companies that sell convertible bonds? So, we'll tell you the bond, but you can convert it into stocks. So, convertible bonds and convertible preferred stock can raise options to the holder, to the individual of the security rather than the issuing firm. Okay? A convertible security typically gives the holder the right to exchange each bond or share of preferred stock because that convertible security could be preferred stock for a fixed number of shares of common stock. So, at any point in time, you can go back to the company, you can go back to Tesla, and if you have one bond, you can exchange, for example, one bond for 10 stocks. That would be great, right? Especially with Tesla prices these days. So, this is basically where it is. You give them the bond, they give you 10 stocks in return. Regardless of what the market price is, it doesn't matter. The conversion is one bond for 10 stocks or one bond for 15 stocks or one bond is for 5 stocks. Whatever that conversion is, you as the holder, you have the right to do so. So, let's take a look at some numbers or some example. A bond with a conversion ratio of 2 allows the bond holder to convert one bond, par value $1,000 into 10 shares of stocks. Simply put, what we're saying, the conversion price is $100. So, to receive 10 shares of stock, you will give them $1,000. You'll give them the bond and they'll give you 10 stocks. Simply put, the bond face value is $1,000 and if they're giving you 10 stocks, it means each stocks, the implied price is $100, the implied value is $100, the implied price of the conversion. So, a bond worth $950. So, if you can get your hands at a bond that's worth $950 with a conversion of 10, then what you're doing is you are buying each stock for $95 because now you paid $950. You can convert into 10 stocks. Simply put, you are paying $95 per share. Obviously, if you can buy the stock at $900, have a conversion of 10, then you're buying basically the stock for $90. So, most convertible bonds are issued deep out of the money. So, they don't let you convert upfront. They will make it deep out of the money. So, how did they make it deep? The issuer sets the conversion ratio that the conversion will not be profitable unless there is a substantial increase in the stock price. So, the stock price went up substantially. So, here if they tell you, you can exchange one bond, which is $1,000 into 10 stocks, the implied value is 100. The implied value is 100. Well, if the implied, if the value right now is 150, that's great. You just go ahead, you will exchange your stocks into bonds. You will exchange your stocks into bonds. But usually what happens is if they give you this conversion, usually the stock price is trading at maybe 60. So, you don't convert now. Why? Because if you convert, you're technically paying $100 per share based on your face value. Now, what happens is if the stock price goes up to 110, then the conversion is worth it because you can buy the stock at 100 and sell it immediately for 110 and pocket the profit. So, when they issue it, initially it's out of the money. So, the stock will be trading at 60. So, then they don't give you any incentive to convert. But when would you have an incentive to convert? Well, for talking about this 10 conversion, 10 stocks conversion ratio, if the stock exceeds 100, then it's worth it. Or if you can buy this, if you can buy the bond at a deep discount. So, if you can buy this bond for $500 and you can convert it into 10 stocks, so you can buy the bond for $500, convert it into 10 stocks, then your cost per share is 50 and the stock is trading at 60, then it's worth it for you. So, usually when they initially issue it, it's out of the money. If that's not the case, think about it. Everybody will be doing the same thing. They will buy the bond and convert, buy the bond and convert, and eventually, they will keep bidding the price up or the price down until we reach market equilibrium. Warrants. Warrants are another type of option-like securities. Warrants are essentially coal options issued by the firm. So, simply put, the option that the firm will sell you the stock at a certain price. That's what the warrants are. But there's a little bit of important differences between calls and warrant. The exercise of the warrant required the firm to issue new shares of stock to satisfy its obligations. So, basically, warrant means, well, we're going to sell you options now. And at some point, you can come back. And if you want stocks, for example, they would say you can buy the stock at $40. So, when you come back for a period of time, for example, you pay for the warrant, like for example, $3 for the warrant. In the next two years, anytime you'd like to, we will sell you the stock at $40. So, they'll have to issue new shares of stocks, which will increase the number of shares outstanding. And there are consequences to that. If you remember, we talked about earnings per share, that's going to reduce your earnings per share. But unlike call options, warrant provide a cash flow to the firm. So, when you come back and pay them $40, well, this $40 goes to the firm. So, it's going to provide cash flow to the firm because you exercise at that price $40. Well, basically, these differences mean warrant value will differ somewhat from the value of the call option with identical terms. So, they're a little bit different because the company is receiving all the money and issuing new stocks. So, the value, how we value this transaction is a little bit different than a straight call option. But like convertible, that warrant terms may be tailored to meet the needs of the firm. So, just like with convertible, that they can write the contract in any way for time period or any conditions they can put on because that's what they want. They want the raise in the money. So, it's an agreement between you and them. Also, like convertible bond, warrants generally are protected against stock split and dividend in that the exercise price and the number of shares are adjusted. So, if they do the stock split, now if you can buy one share and they do two for one, now you can buy two shares. So, they do adjust them. So, you are protected. And warrants are often issues in conjunction with other securities. So, for example, if the company is raising money through that, what they do is say, okay, buy the bond and along the bond will give you some warrant. Those are called sweeteners. So, they want to entice you. They want to entice you to buy the bond. So, what would they do? They'll try to convince you. Well, buy the bond and will give you a warrant with it. So, you buy the bond and you can buy stocks at a certain price for the next two to three years. Okay. Sometimes they're called detachable warrant. Okay. Detachable means the bond, the warrant itself can be sold separately from the bond. So, if you have the bond and the warrant, sometimes they are detachable. Sometimes they are not detachable. And this is what I cover in my intermediate accounting courses. You have to learn how to do accounting, journal entries for transactions such as those. So, here we're going to assume that they are detachable. It means you can sell the warrant and keep the bond or keep the bond and sell the warrant. You could just do whatever you would like to. Issues of warrant and convertible securities create the potential for an increase in outstanding shares, which in turn they might dilute the share and will have, you know, you have to be careful when you value the company because they dilute EPS. So, exercise obviously would affect the financial statistics that are computed on a per share basis. So, annual report must include earnings per share figures under the assumption that all convertible are converted. So, there's something called what if analysis and you'll have to show what if those options like securities are converted. And this is where you would go into basic earnings per share and diluted the earnings per share. So, the company will have to show both basic EPS and it would always show if they have any of those convertible securities, they have to compute diluted EPS assuming it's dilutive and they'll have to report both numbers. Collateralized loan. Basically, what is collateralized loan? You went to borrow money and they ask you for a collateral. Okay? Many loan agreements require that the borrower put up a collateral to guarantee the loan will be paid back. Now, why are these option like securities? We're going to explain why. In the event of the fault, the lender take possession of the collateral. So, in case you default, they will take the house, the car, the warehouse, whatever you put up as collateral. Now, if we have a non-recourse loan, it basically gives the lender no recourse beyond the right of the collateral. So, if the loan is non-recourse, it means all what the borrower would lose is whatever they put up as collateral. Under those circumstances, the lender may not sue the borrower for further payment. Okay? If the collateral turns out not to be valuable enough to repay the loan. So, with this non-recourse loan, well, if the collateral is not that good, guess what? You know, and the lender and the borrower don't pay, well, you're stuck with the losses. So, you have to, the lender is very careful when they provide those non-recourse loan because that's all what they can go after. It's that particular asset that you pledge as a collateral. So, basically, the arrangement, in a sense, gives an implicit. Notice here, there is no explicit. There is no right for the for the borrower. But there's an implicit call option. How so? Let's assume the borrower is obligated to pay $100,000 at maturity of the loan. That's the agreement. And now the collateral is worth only $80,000 at maturity. What would you do? Why would I do? I would let them take the collateral. If it's a non-recourse loan, a business loan, and that's all what we agreed on, and, you know, that's the warehouse that I put up, and it's only worth $80,000, and I have to pay $90,000, I will default on the loan. So, okay, take the warehouse and keep the loan. So, the borrower, in a sense, have the option to wait until the loan is due, and repay it only if the collateral is worth more than $100,000. Now, if you have a collateral for $150,000, you don't want to default on the loan because they're going to take your warehouse, that's worth $150,000. But if it's less, you have that option. Obviously, bankers and lenders, they're smart enough to know if they're going to give you a non-recourse loan. They will make sure the value is two or three times the amount of the loan if it's a non-recourse loan. But also, it could be two or three times. I mean, at some point, banks, they were giving line of credit in loans to oil producers. And what happened at that point, they were giving the loan against oil that's already in the ground. And at that point, the barrel of oil was worth $120, $130. And when they wrote those loans, it was based on that value. Then, I'm sure you're following what's happening to the price of oils. I'm not sure it's like what, around $30, $40 now. So if the price of that inventory goes down and you have a loan, you'll tell the bank, look, you can have the barrels of oils yourself. I don't need them. So you have to be very careful, but banks are pretty good at this. Well, yes and no, because also in the financial crisis, many people walked away from their homes because of this option. But remember, if you walk away from your home, you're not only losing your home, you're losing your credit. And this is what they get you by. So if the collateral is less than $100,000, the borrower might default, discharging the loan, and fortifying the collateral. Another way of describing the loan is to view the borrower as turning over the collateral and instead of the, to pay off the loan. That's what we're doing here. So that's why, in a sense, it's an option like, it's an option like security. We also have leverage, equity and risky debt. Basically, what it means is if you are an investor holding stocks in any company, you are protected by something called limited liability, which means that the maximum you would lose, the maximum you'd lose is the amount that you invested in those stocks. So if the firm cannot pay its debt, the firm creditor may attach only the firm's asset and may not sue the corporation, equity holder for further payments. If you're a stockholder, the maximum you would lose is the amount that you invested. So in effect, anytime the corporation borrows money, the maximum possible collateral is the total assets firm. That's all what you can, that's all what the investors could lose is whatever assets they have inside the company. So if the company declared bankruptcy, well, what does that mean? It means it's an admission that the firm's asset are not sufficient to satisfy the claims against it. Obviously, if you cannot pay off your debt, it means you don't have enough asset. Okay. So the corporation may discharge its obligation by transferring ownership of the firm asset to the creditor. So what you do is you tell them, okay, we can pay off our debt, take the assets, they're not worth that much. It's the same thing as we talked about earlier, collateralized loan. It's like, okay, the loan is not worth it. I'm not going to pay off the loan because I don't have enough asset to, you know, the asset, the collateral that I put up, the assets that I have is worth less than the loan. So you take over the company, you take over the assets. Okay. So just like it's true for non-recourse collateralized loan, the equity holder have a put option to transfer their ownership claim on the firm to the creditors and return for the face value of the firm's debt, whatever they deferred that. Another way to look at this, we can say that the equity holders retaining a call option. In what sense the call option, they have implicitly, again, those are implicit options, implicit transfer their ownership claim to the firm to the creditors, but have retained the right to require it by paying off the loan. If they don't want you to take over, they'll pay off the loan, basically put. So they have the option to give it up and they have the option to keep it. Therefore, the equity holder has an implicit option to buy back the firm for a specified price. And what they would do at this point, they may even negotiate with you if you want to just write off the loan 20-30% and we'll pay it off. This is where valuation will come into place. So the significance of this observation is that analysts can value corporate bond using option-like techniques. So the default premium required of risky asset and principle can be estimated using option valuation model. And for this course, we're not going to cover option valuation because it's beyond the scope of the course, but it's basically, that's the basic idea. In the next session, we'll start to look at the future market and risk management. As always, I'm going to remind you to like this recording, share it, and please visit my website farhatlectures.com if you are looking for additional resources to supplement and complement this course as well as many other courses. Good luck, study hard, and stay safe.