Introduction

This chapter explores three distinct financial instruments that share common traits with traditional stock options but serve different purposes. Warrants, convertible bonds, and employee stock options are essential components of modern financial markets, offering unique opportunities and challenges for investors and corporations alike. Understanding these instruments is crucial for a comprehensive grasp of options markets.

Warrants

Definition: Warrants are financial derivatives that grant the holder the right, but not the obligation, to buy a specific number of underlying securities (usually common stock) from the issuer at a predetermined price within a specified time frame. Warrants are often used as incentives, investment tools, or as a way for companies to raise capital.

Features and Types of Warrants: There are two main types of warrants: investment warrants and covered warrants. Investment warrants are issued directly by the underlying company, while covered warrants are issued by financial institutions. Warrants have an exercise price (strike price), a maturity date, and can be traded on various exchanges.

Example: Imagine Company ABC issues warrants for its common stock at a strike price of $50, with a maturity of two years. If the market price of ABC’s stock rises to $60 within the maturity period, warrant holders can purchase the stock at the predetermined $50 price, making a profit of $10 per share.

Convertible Bonds

Convertible bonds are debt securities that can be converted into a predetermined number of the issuer’s common stock shares. They offer investors the potential for capital appreciation while providing downside protection through their bond component. Convertible bonds are a hybrid investment, combining elements of both debt and equity.

Conversion Ratio and Premium: The conversion ratio determines how many shares of common stock each bond can be exchanged for. The conversion premium reflects the price of the convertible bond compared to the value of the underlying common stock at the time of issuance.

Example: A company issues convertible bonds with a $1,000 face value, a conversion ratio of 10, and a conversion premium of 20%. If the common stock is trading at $90 per share, the bondholder can convert each bond into 10 shares of stock, which have a market value of $900, plus the remaining bond value.

Employee Stock Options (ESOs)

Employee stock options are granted by companies to their employees as a form of compensation and incentive. ESOs grant employees the right to purchase a specific number of company shares at a predetermined price, usually referred to as the exercise price or strike price. These options often have vesting periods and expiration dates.

Vesting and Incentive: Vesting refers to the gradual accumulation of ownership rights by employees over time. ESOs incentivize employees to contribute to the company’s success, aligning their interests with shareholders.

Example: An employee receives 1,000 ESOs with a strike price of $50. If the company’s stock price rises to $70, the employee can exercise the options, purchasing shares at $50 and making an immediate profit of $20 per share.