MODULE 3

AN OVERVIEW OF HYBRID AND DERIVATIVE SECURITIES

TOPICS
1. An Overview of Hybrid and Derivative Securities
2. Form of Hybrid Security – Leasing
3. Form of Hybrid Security – Convertible Securities
4. Form of Derivative Security – Stock Purchase Warrants
5. Form of Derivative Security – Options

LEARNING OUTCOMES
At the end of the lesson, you should be able to:
1.
Discuss the overview of hybrid and derivative securities;
2.
Discuss the definition of leasing;
3.
Differentiate the types of leasing;
4.
Identify and explain leasing arrangements;
5.
Differentiate leasing from purchase decision with the application of the time
value of money;
6.
List and explain the advantages and disadvantages of leasing;
7.
Discuss the definition of convertible securities;
8.
Differentiate the types of convertible securities;
9.
Compute the conversion ratio;
10.
Determine the value of the convertible bond; and 11. Discuss and explain
stock purchase warrants and options.
 TOPIC 1: AN OVERVIEW OF HYBRID AND DERIVATIVE SECURITIES
Hybrid Security
A hybrid security is an investment instrument that combines two or more
different financial instrument (i.e. bonds, equity). It's a term used frequently as “hybrids”
because it generally combines both debt and equity characteristics. Preferred stocks,
financial leases, convertible securities,
and stock purchase warrants are some Return
of the most common hybrid
instruments.
Equity
According to Spiegeleer (2014),
hybrid securities are often
Hybrids
misunderstood and mismanaged
because they are not equity
instruments with bond-like risk and Bond
neither are they instruments with
bond returns flavored with equity risk. Risk
Yet hybrids may give a predictable
fixed or floating rate of return or dividend until a certain date (SIC, 2013).

Note
• Some of the forms of hybrid securities are so complicated which makes it difficult
to identify whether it is a debt or equity.
• Another criticism for hybrids is that it offers higher investment risk than the debt
security such as bond and lower than the equity security.

Derivative Security

A derivative is a contract between two or more parties based on a single asset or a

group of assets. It’s worth is influenced by the following factors: the value of another
asset, and its price is derived from variations in the underlying asset. Stocks, bonds,
currencies, interest rates, and market indexes are the most frequent fundamental assets
for derivatives, and they are often acquired through brokerages or securities firms.

Derivatives were first employed to ensure that items traded globally had balanced
exchange rates. International traders needed a mechanism to account for the disparities
in national currencies' values. Derivatives are now based on a wide range of transactions
and have a wide range of applications. There are various weather derivatives available,
such as the amount of rain or the number of sunny days in a certain place (Fernando,
2021).

Four (4) General Features of Derivatives

1. Use. All derivatives can be used to mitigate (hedge) the risk associated with a
particular financial exposure.
2. Trading. In the over-the-counter (OTC) market, derivatives can be exchanged on
regulated marketplaces or as private treaties between two or more counterparties.
Derivatives have a visible price in an organized market, such as a stock exchange or a
futures exchange.

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3. Leverage. Traders can acquire market exposure with little or no initial investment
using any derivative.
4. Outcomes. Derivatives will eventually expire according to a set schedule or in
response to a specific event. After this, derivatives are worthless. Traders may be
required to settle their derivative holdings at expiration, which may include the
exchange of cash or other assets between counterparties.

Advantages of Derivatives
1. For both corporations and investors,
derivatives can be a helpful instrument. They allow
you to lock in prices, hedge against unfavorable rate
fluctuations, and manage risks—all at a low cost.
2. Furthermore, derivatives are frequently
purchased on margin—that is, with borrowed funds
—making them even more affordable.

Disadvantages of Derivatives
1. Derivatives are difficult to appraise because they are depending on the price of
another asset.
2. Counter-party risks, which are difficult to foresee or assess, are among the
hazards associated with OTC derivatives.
3. Changes in the amount of time till expiration, the cost of holding the underlying
asset, and interest rates all have an impact on most derivatives. It's difficult to match the
value of a derivative to the underlying asset because of these factors.

TOPIC 2: FORM OF HYBRID SECURITY – LEASING

Leasing
Leasing is a technique of obtaining fixed assets for a corporation in exchange for a series
of contractually agreed-upon, periodic, tax-deductible payments. This process involves
two (2) parties: the receiver (lessee) who receives the assets' services under a lease
contract and the owner (lessor) who leased his fixed assets.

There are two (2) types of leasing: (1) An operating lease is a contract in which
the lessee agrees to pay the lessor on a regular basis for the use of an asset or services,
usually for a period of 5 years or less.; and (2) The lessee is obligated to make payments
for the use of an asset over a predetermined length of time under a financial (capital
lease).

Operating vs. Financial Lease (Streetfleet, 2013)

Operating Lease Financial (Capital) Lease
 Cancellable.  Non-cancellable.
 Payable for five (5) or fewer years.  Payable for more than five (5)
years.
 The lessor retains ownership of the  At the end of the lease term, the
property during and after the lease lessee receives ownership of the
term. property.
 The total payments during the  The total payments over the lease
lease's tenure are less than the term exceed the lessor's original
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 leased asset's initial cost to the investment in the leased asset.
lessor.
 It's for clients who don't want to  It is a credit facility in which the
deal with the hassles of acquisition lessor acquires fixed assets based
and disposition and don't want to on the requirements/needs of the
take on the risks and rewards of client (lessee), which the client
asset ownership. (lessee) then leases from the
lessor for an agreed period of time
by paying periodic lease
amortization. e.g., LBP Leasing
and
Finance Corporation (LLFC)
Maintenance, Renewal and Purchase Options

In an operating lease, the lessor is responsible for asset maintenance and insurance tax
payments, but in a financial lease, the lessee is responsible for maintenance and other
costs. Both give the lessee the option to re-lease assets or extend the contract at the
end of the term, but operational leases are more popular because the period is usually
shorter than the useful life of the leased assets. Both operating and finance leases
usually include provisions allowing the lessee to purchase the leased asset at maturity
for a pre-determined price.

Leasing Arrangements
1. Lease-to-own. This happens when a lessor owns or acquires the assets that are leased
to a certain lessee. To put it another way, the lessee does not own the assets it is leasing.
2. It's a sale-leaseback deal. When lessors acquire leased assets by purchasing assets
that the lessee already owns and leasing them back to the lessee, this is known as
leaseback. (Tardi, 2020).
3. Leveraged lease. It's a type of lease in which the lessor operates as an equity partner,
providing just around 20% of the asset's cost while a lender covers the rest.

The Lease-Versus-Purchase Decision

The decision, facing firms needing to acquire new fixed assets; whether to lease
the assets or to purchase them, using borrowed funds or available liquid resources.

Steps in Making Decision Whether to Lease or Purchase:

Step 1 Find the after-tax cash outflows for each year under the lease alternative.
Step 2 Find the after-tax cash outflows for each year under the purchase alternative.
Step 3 Calculate the present value of the cash outflows associated with the lease and
purchase alternatives using the after-tax cost of debt as the discount rate. The
after-tax cost of debt is used to evaluate the lease versus purchase decision
because the decision itself involves the choice between two financing
techniques- leasing and borrowing that have very low risk.
Step 4 Choose the alternative with the lower present value of cash outflows from step 3.
It will be the least – cost financing alternative.

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 Example:

ABC Company is considering investing P24,000 in a new equipment. Leasing or

purchasing the machine might be arranged. The corporation is taxed at a rate of 40%,
with a tax cost of debt of 6%.

Lease. The corporation would sign a 5-year lease with annual lease payments of P6,000
at the end of each year. The lessor would cover all maintenance costs, but the lessee
would be responsible for insurance and other expenses. At the end of the lease, the
lessee will have the opportunity to purchase the equipment for P4,000.

Purchase. The company plans to finance the machine's purchase with a 9%, 5-year loan
with P6,170 in end-of-year installment payments. Under MACRS, the machine would be
depreciated over a 5-year recovery period. The corporation would pay P1,500 per year
for a service contract that would cover all maintenance expenditures, as well as
insurance and other expenses. The company intends to maintain the machine and put it
to good use.

Step 1 Find the after-tax cash outflows for each year under the lease alternative.

The after-tax cash outflow from the lease payment can be found by multiplying the
before tax payment of P6,000 by 1 minus the tax rate, T, of 40%.

After tax cash outflow from lease

= P6,000 x ( 1 – T )
= P6,000 x ( 1 – 0.40 )
= P 3,600

Total cash outflow in year 5

= P3,600 + P4,000
= P7,600

Step 2 Find the after-tax cash outflows for each year under the purchase alternative.

Table 1. Determining the interest and principal components of the Roberts

Company Loan Payments
Loan Beginning of Interest Principal End of year -
Year year - Principal
Payments

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 Principal
To calculate the loan payments for purchase alternative, 3 use the formula:
4 5
1 2
0.09 x (2) (1) – (3) (2) – (4)
FVIF = { 1 - [ ( 1 + i )n ]/ i } where “i" is the interest rate and “n” is the number of years
1 P6,170 P24,000 P2,160 P4,010 P19,990
= 3.890
2 P6,170 P19,990 P1,799 P4,371 P15,619
3
Loan payments P6,170 P15,619 P1,406 P4,764 P10,855
4= P24,000/3.890
P6,170 P10,855 P977 P5,193 P5,662
5= P6,170 P6,170 P5,662 P510 P5,660 -
Note: Difference of P2 on Year 5 ending principal is due to rounded values
Table 2. After-Tax Cash Outflows associated with purchasing for Roberts Company
After-tax
Loan Maintenance Total Tax
Depreciation Interest Cash
Payments Cost Deductions Shields
Outflows
Year
5 6 7
1 2 3 4 (2) + (3) + 0.40 x (1) + (2)
(4) (5) – (6)
1 P6,170 P1,500 P4,800 P2,160 P8,460 P3,384 P4,286
2 P6,170 P1,500 P7,680 P1,799 P10,979 P4,392 P3,278
3 P6,170 P1,500 P4,560 P1,406 P7,466 P2,986 P4,684
4 P6,170 P1,500 P2,880 P977 P5,357 P2,143 P5,527
5 P6,170 P1,500 P2,880 P510 P4,890 P1,956 P5,714

Table 3. Present Value of Outflow for Leasing and Purchasing

Leasing Purchasing

After-tax Present Present After-tax Present Present

Year Cash Value Value of Cash Value Value of
Outflows Factors Outflows Outflows Factors Outflows
3 6
1 2 4 5
(1) x (2) (4) x (5)
1 P3,600 0.943 P3,395 P4,286 0.943 P4,042
2 P3,600 0.890 P3,204 P3,278 0.890 P2,917
3 P3,600 0.840 P3,024 P4,684 0.840 P3,935
4 P3,600 0.792 P2,851 P5,527 0.792 P4,377
5 P7,600 0.747 P5,677 P5,714 0.747 P4,268
PV of Cash Outflows P18,151 PV of Cash Outflows P19,539

To compute the PVIF use the formula:

PVIF = 1 / ( 1 + tcd )n where “tcd” is tax cost of debt

To compute for the Tax Cost of Debt, use the formula:

Tax Cost of Debt = [ i x ( 1 – tb )] where “tb” is tax bracket

= [ 9 x ( 1 – 0.40 )]

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Step 3 Calculate the present value of the cash outflows associated with the lease and
purchase alternatives using the after-tax cost of debt as the discount rate. The
after-tax cost of debt is used to evaluate the lease versus purchase decision
because the decision itself involves the choice between two financing
techniques- leasing and borrowing that have very low risk.

Step 4 Choose the alternative with the lower present value of cash outflows from step 3.
It will be the least – cost financing alternative.
*because the present value of cash outflows for leasing ($18,151) is lower than
that for the purchasing ($19,539), the leasing alternative is preferred. Leasing
results in an incremental savings of $1,388 ($19,539 - $18,151) and is therefore
the less costly alternative.

Advantages of Leasing
1. If the lessor fails to precisely predict asset obsolescence and makes the lease
payment too low, the firm may escape the cost of obsolescence. (Borad, 2015)
2. Many of the restrictive covenants that are often imposed as part of a long-term
loan are avoided by a lessee.
3. Leasing – particularly operating leases – may provide the organization with
needed financing flexibility in the event of low-cost assets that are acquired infrequently.
(Borad, 2015)
4. The firm may be able to enhance its liquidity by converting an existing asset into
cash, which can subsequently be utilized as working capital, thanks to sale-leaseback
contracts. 5. Leasing permits the lessee to depreciate land in a way that would be illegal
if the land were acquired.
6. Leasing provides 100% financing. (Obaidullah, 2020)
7. When a company goes bankrupt or reorganizes, lessors can only make a claim for
three years' worth of lease payments, and the lessor receives the asset back.

Disadvantages of Leasing
1. Because the return to the lessor is often high in leases, the company might be
better off borrowing to buy the asset.
2. The lessor realizes the salvage value of an asset, if any, at the conclusion of the
lease agreement's term. (Desai, 2019)
3. A lessee is normally barred from making improvements to the leased property or
asset without the agreement of the lessor under the terms of the lease. (Borad, 2015)
4. If a lessee rents an asset that becomes obsolete later, it must continue to make
lease payments for the remainder of the lease period.

TOPIC 3: FORM OF HYBRID SECURITY – CONVERTIBLE SECURITIES

Convertible Security

A convertible security is one that can be converted into another type of investment.
Convertible bonds and convertible preferred stock, which can be converted into
common stock, are the most common examples of this form of investment. (Kenton,
2021). The conversion feature usually improves an investment's marketability. A
convertible security specifies the price at which it can be converted and pays a defined
amount on a regular basis—in the case of convertible bonds, a coupon payment, and in
the case of convertible preferred shares, a preferred dividend.

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 Bond is an instrument of indebtedness of the bond issuer to the holder. Bond is
an interest-bearing security that obligates the issuer to pay the bondholder a specified
sum of money, usually at specific intervals (known as coupon), and to pay the principal
amount of the loan at maturity (McCamish, 2020). The lessee is normally barred from
making improvements to the leased property or asset without the permission of the
lessor under the terms of the lease. A convertible bond can be converted into a specific
number of common stock shares. It's almost always a debenture, which is an unsecured
bond with a call option. (Tracy, 2021).

A corporation's capital is raised through the distribution of shares, which is

known as stock. Common stock and preferred stock are the two forms of stocks. The
owner of common stock is normally entitled to vote at shareholder meetings and receive
dividends. Although preferred stock does not have voting rights, it does have a larger
claim on assets and earnings than common stock. For example, owners of the preferred
stocks receive dividends before common shareholders and have priority in the event
that a company goes bankrupt and is liquidated. Convertible Preferred Stock can be
exchanged for a set number of common stock shares. It can usually be sold with a lower
declared dividend than a nonconvertible or straight preferred stock with a similar risk
profile. The reason for this is that the holder of a convertible preferred stock is
guaranteed to receive the set dividend payment associated with a preferred stock and
may also benefit from rises in the market price of the underlying common stock.

Special Considerations
1. The corporation is issuing the securities wants to be able to compel the investor
to buy. The corporation accomplishes this by incorporating a call feature, which allows it
to redeem bonds based on criteria established at the time of issuance. Making the
bonds callable at or around the conversion price is a popular example.
2. The corporation saves money by not paying interest, and the investor receives a
return of capital or common stock equal to the amount invested.

General Features of Convertibles

The ratio at which a convertible security can be exchanged for common stock is
known as the conversion ratio. “To convert the security or not to convert the security
into shares of common stock?” is a frequently asked question. You might be able to
answer the relevant question in this topic by examining the data you've gathered and
computed. However, the conversion ratio is not always applied. There other means to
know if it would be better to convert the security or not such as finding the conversion
value. Knowing the market value and market price of the common stock per share is
necessary.

Conversion ratio can be stated into two ways:

The conversion ratio is sometimes expressed in terms of a specific number of

shares of common stock. Divide the par value (not the market value) of the convertible
security by the conversion ratio to get the conversion price, which is the per share price
that is effectively paid for common stock as a result of conversion.

Example:

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Memory Company has an outstanding convertible 20–year bond with a par value of
P1,000. The bond is convertible at P50 per share into common stock. The conversion
ratio is 20 (P1,000 ÷ P50).

In some cases, the conversion price is supplied instead of the conversion ratio.
The conversion ratio is calculated by dividing the convertible's par value by the
conversion price.

Example:

Lokal Wear Company, a manufacturer of denim products, has an outstanding a bond that
has a P1,000 par value and is convertible into 25 shares of common stock. The bond’s
conversion ratio is 25. The conversion price for the bond is P40 per share (P1,000 ÷ 25).
Conversion (or Stock) Value is the convertible's value expressed as a percentage
of the market price of the common stock into which it can be converted. The conversion
value can be found simply by multiplying the conversion ratio by the current market
price of the firm’s common stocks.

Example:

A P1,000 bond issued by McJobee Industries, a petroleum processor, is convertible into

common stock for P6.50 per share. As a result, the conversion ratio is 16 (P1,000
P62.50). Because the common stock is currently trading at P65 per share, the conversion
value is P1,040 (16 x P65). Conversion is a reasonable alternative for the owner of the
convertible security because the conversion value is more than the bond value of
P1,000.

Determining the Straight Bond Value

Straight Bond Value is the price it would sell for on the market if it didn't have
the conversion feature. It's usually the lowest, or floor, price at which the convertible
bond can be sold.

Example:

Duncan Company, a cheap store operator in the South, has offered a P1,000 par value,
20-year convertible bond with a coupon rate of 12%. At the end of each year, the bond's
interest will be paid, and the principal will be reimbursed at maturity. A 14 percent
coupon interest rate could have been offered on a straight bond, but the convertible's
conversion feature compensates for the lesser rate.

Solution:

Present Value
Payments Present Value
Interest at 14%
Year
3
1 2
(1) x (2)
1-20 P120 6.623 P794.76
20 P1,000 0.073 P73.00
Straight bond value P867.76
P867.76 is the minimum price at which the convertible bond is expected to sell. Generally, only in
8
 certain instances in which the stock’s market price is below the conversion price will the bond be
expected to sell at this level.

Note: Use the following formula for the computation of the Present Value Interest
Factors for the Peso Discounted at “i" Percent for “n” periods: PVIF = 1/(1 + i)n or 1/(1 +
0.14)20 = 0.073 and Future Value interest factors for a one Peso Ordinary Annuity
Compounded at “i" Percent for “n” periods: FVIFA = [1 – ( 1 + i ) n]/i use this formula for
the result of 6.623.

Conversion (stock) value

Example:

Duncan Company’s convertible bond described earlier is convertible at P50 per share.
Each bond can be converted into 20 shares, because each bond has a P1,000 par value.
The conversion values of the bond when the stock is selling at P30, P40, P50, P60, 70,
and P80 per share are shown in the following table.

Solution:

Market price of stock Conversion value

P30 P600
P40 P800
P50 (conversion price) P1,000 (par value)
P60 P1,200
P70 P1,400
P80 P1,600

Note: The conversion value exceeds the P1,000 par value when the market price of
the common stock exceeds the P50 conversion price. Because the straight bond value
(determined in the preceding example) is P867.76, regardless of how low the conversion
value is, the bond will never sell for less than this amount in a stable environment. The
bond would still sell for P867.76 – not P600 – if the market price per share was P30,
since its worth as a bond would dominate. The market value is more likely to be higher
than the straight or conversion value. The market premium is the amount by which the
market value exceeds its straight or conversion value.

TOPIC 4: FORM OF DERIVATIVE SECURITY – STOCK PURCHASE WARRANT

Stock Purchase Warrant

Stock purchase warrants are similar to stock rights in that they allow you to buy
stock. Warrants are a type of derivative that gives you the right but not the duty to
purchase or sell securities (usually equity) at a specific price before it expires. The price
at which the underlying security can be bought or sold is referred to as the exercise price
or strike price (Chen, 2020). It allows the holder to purchase a set number of shares of

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common stock at a set price over a set period of time (holders of the said warrants earn
no income from them until the warrants are exercised or sold).

As a sweetener, warrants are issued in conjunction with bonds, resulting in

warrant-linked bonds, allowing the issuer to provide a lower coupon rate. These
warrants are frequently detachable, which means they can be detached from the bond
and traded on the secondary market before they expire. In addition to preferred stock, a
detachable warrant can be issued.

The exercise (or option) price is the price at which holders of warrants can
acquire a specific number of shares of common stock. Normally have a life span of no
more than ten years, while some can survive indefinitely. Warrant Trading is also a
detachable warrant, meaning that the bondholder can sell the warrant without selling
the security to which it is linked. On established securities markets and over the counter
exchanges, several detachable warrants are listed and frequently traded.

Value of Warrants

Theoretical Value of Warrants – is the amount one would expect the warrant to sell for
in the marketplace. TVW = (P0 – E) x N

Where:
TVW = theoretical value of warrant
P0 = current market price of a share of common stock
E = exercise price of the warrant
N = no. of shares of common stock obtainable with one warrant

Example:

Justin Electronics, a prominent transistor manufacturer, has outstanding warrants that

permit holders to purchase three shares of common stock for P40 per share. The
warrants were originally linked to a bond issue in order to sweeten it. The firm's
common stock is now trading at P45 per share.

Substituting: P0 = P45, E = P40, and N = 3 into equation.

It yields a theoretical warrant value of P15 [(P45 - P40) x 3)]. Therefore, Dustin’s warrants
should sell for P15 in the marketplace.

Note
1. Most warrants are not posted on major exchanges, and data on warrant issues is
not widely available for free. Trading and finding information on warrants can be
complex and time-consuming.
2. When a warrant is posted on an exchange, it usually has the same ticker symbol
as the company's common stock, with a W appended at the end. Abeona Therapeutics
Inc (ABEO) warrants, for example, are traded on NASDAQ under the ticker ABEOW. In
other circumstances, a Z or a letter specifying the individual issue (A, B, C...) will be
added.
3. Warrants often trade at a premium, which depreciates over time as the expiration
date approaches. Warrants, like options, can be valued using the Black Scholes model.

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 TOPIC 5: FORM OF DERIVATIVE SECURITY – OPTIONS
Options can be thought of as a financial instrument that allows its owner to buy
or sell a specific asset at a predetermined price on or before a given expiration date. The
most popular sort of derivative security is undoubtedly options. These contracts allow
buyers the option to buy (calls) or sell (puts) a predetermined amount of the underlying
asset at a predetermined price (the strike price) before or at expiration. (Davis, 2021).
They can be exchanged over the counter, but the majority is traded on exchanges. The
payoffs from option positions are non-linear in relation to the underlying's price.
Computer models that use discounted cash flows and statistically predicted future prices
of the underlying asset determine option premiums. Rights are financial tools that allow
owners to buy more shares at a lower price than the market price, in proportion to the
amount of shares they own.

Call Option

According to Roya (2021), A call option is a contract that allows you to buy a certain
number of shares of stock (usually 100) at a certain price on or before a certain feature
date. Usually have initial lives of 1 – 9 months, occasionally 1 year. The striking price is
the price at which the older of the option can buy the stock at any time prior to the
option’s expiration date.

Put Option

It's a contract to sell a certain number of shares of a stock (usually 100) at a certain price
on or before a certain date in the future (Sraders, 2019). The striking price of a put
option, like that of a call option, is set close to the underlying stock's market price at the
time of issuance. Puts have lifetimes and costs that are identical to calls.

Option Trading

The assumption that the market price of the underlying stock will climb by more
than enough to pay the cost of the option, allowing the call option buyer to profit, is the
most prevalent reason for buying call options. Option trading is simply the act of trading
options on securities traded on the stock or bond markets (as well as ETFs and the like).
Only through brokerages or intermediaries can you buy or sell options.

Assessment:
Instructions: Copy questions and answer each number. Send it to my messenger. Neofe Javier Lazaro in JPG
format, handwritten is allowed. Thank you.
1. What is hybrid security? Give an example.
2. Identify and explain leasing arrangements.
3. Differentiate leasing from purchase decision with the application of the time value of money
4. Differentiate the two-conversion ratio.

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