Question

Define, explain use/why and list benefits and disadvatages of Convertible Security, Warrants, and Derivatives

Answer 1

1. Convertible security

They are the securities which can convert in to another security.

bonds or preferred stock which includes regular interest converted in to common stock at the option of the holder.

Uses or why its used by the companies :

a.Companies issue these securities to lower the coupon rate on debt.investors wants lower coupon rate on convertible bonds than on other  regular bonds, because of its conversion feature. It help the company to save the interest expenses , which can be substantial in huge bond issue.

b.Also to delay dilution. Increase in capital by these securities rather than equity allow the company to delay dilution to its equity holders.

Benefits :

a.company can sell this securities at lower coupon rate than standard bonds due to stock purchase option.

b.company can secure equity financing.

c.bond interest is tax deductible expense.

d. Safety in bear market to investors.

e. Investor can convert in to stock when its high value.

Disadvantages :

a.liquidity risk.when stock declines, associated Cinvertible bond also declines, because its protected by its value as a fixed income instrument.

b.risk of diluting not only the EPS of company's equity, but also control of the company.

2. Derivatives

Its a financial instrument whose value is depends upon the value of another Underlying asset. Forward,future ,option and swaps are major types.

Uses :

a.derivatives shift the risk from the buyer to the seller .soits a good risk management tool.

b.for improving liquidity of underlying assets. They helps for better price discovery of underlying securities.

c. Hedgers uses this security to protect their assets from eroison in value due to market volatility.

d. Traders uses to increase their income by making 2 way price for other market participants.

e. Speculators for making quick money

F. Act as a barometer of future trends in prices

Benefits :

a. Hedging risk factor by linking to the value of underlying assets.

b.better market efficiency

c.leverage or gearing feature. With small initial funds , a person can deal huge volumes

d.low transaction cost

e.price discovery function

F.helps in portfolio management

Disadvantages :

a.may promote speculative or gambling in market.

b.high risk,especially in over the counter market,where self regulated.

c.may include malpractices or frauds which leads to instability in financial system

3. Warrants

These are issued by firms. There are many types of warrants.as security market warrants , they are the securities allow the holder to buy the underlying stock of issuing firm.they will be attached to other securities.

Uses :

a.it allow the firm to pay low dividend or interest rates

b.for increasing bond yield

c.for attracting potential buyers

D allow the owner for Portfolio protection

Benefits :

a.it makes non converible and other debenture more attractive.

b.debenture along with warrant are able to create own market. Also reduce company dependence on financial institutions

c.warranta can be exercised in future date, its cash flow and strucure of capital are planned based on that.

d.are Attachable to other securities

Disadvantages :

a.it is not carry voting right

b.not get dividend or interest

c.may occur huge loss

d.high risky

e.diminishing time value

Hope you understand.