Financing With Derivatives Introduction - Financial Management

Options and option -related financing play an important role in the management of a firm’s assets and liabilities. Options are one of two important classes of so -called derivative securities— that is, securities whose value is derived from another asset.Another important class of derivative securities is forward -type contracts, such as futures contracts and forward contracts. Swaps are another important class of derivative securities. A wide array of securities contain option features, including

  1. Short-term options on common stocks, stock market indexes (e.g., Standard & Poor’s 500 index), 30-year Treasury bonds (e.g., interest rate options), and foreign currency options (e.g., on the British pound and Japanese yen). These options are traded on organized exchanges, such as the Chicago Mercantile Exchange and the Chicago Board Options Exchange.
  2. Convertible fixed-income securities, such as debentures or preferred stocks, that may be exchanged for the company’s common stock at the holder’s option. By giving the fixedincome security holder an opportunity to share in any increase in its common stock value, the firm is able to reduce potential conflicts between the fixed-income security holders and stockholders, resulting in lower agency costs.
  3. Warrants, which are options issued by a company to purchase shares of the company’s common stock at a particular price during a specified period of time.Warrants are frequently sold to investors as part of a unit that consists of a fixed-income security with a warrant attached.As a result, warrants are issued by firms for similar reasons as convertible securities.
  4. A rights offering occurs when common stockholders are given an option to purchase additional shares of the company’s common stock, in proportion to the fraction they currently own, at a price below the market value. Also, as we will see in the next section, a firm’s common stock can be understood more fully using an options framework.

This chapter examines the characteristics and valuation of options and option -related financing. An understanding of these concepts is necessary to evaluate the impact that decisions to issue or purchase these types of securities have on shareholder wealth.

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