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Explain what employee stock options, convertible bonds and warrants are.

FRM® Part I · Financial Markets and Products · Options Markets · FRM1.FM.12.e

The idea

Employee stock options are call options a company grants to staff. They are usually struck at the money on the grant date, with a vesting period, a long life, and no right to sell or transfer them. Unvested options are normally forfeited if the employee leaves, and early exercise is common because the holder cannot hedge. Warrants are call options issued by the company itself, often alongside bonds. When employee options or warrants are exercised, the company issues new shares and receives the strike, so existing shareholders are diluted. A convertible bond is a bond that the holder can exchange for a fixed number of shares, the conversion ratio. Conversion price = face value ÷ conversion ratio. Conversion value = conversion ratio × share price. A convertible is a bond plus a call option, so it carries a lower coupon, and the issuer often has a call right that can force conversion.

Formulas

Conversion value of a convertible bond

conversion value = conversion ratio × share price

conversion ratio
the number of shares received per bond
share price
the current share price

The conversion price is face value ÷ conversion ratio. When the issuer calls the bond, the holder converts if conversion value exceeds the call price.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which description best fits an employee stock option?

  1. A call option on the company's shares granted to an employee, typically struck at the money at grant, with a vesting period and no right to sell it - correct
  2. A put option on the company's shares that the employee buys in the market to protect shares heldWhy not: Employee options are calls granted by the company, not puts bought by the employee.
  3. A traded call option on the company's shares, issued by an exchange and cleared by the clearing houseWhy not: Employee options are issued by the company and are non-transferable; they are not exchange-traded contracts.
  4. A bond issued to employees that can be exchanged for company shares at a fixed ratioWhy not: This describes a convertible bond, not an employee option.

Employee stock options are calls given as compensation. They vest over time, are generally forfeited if unvested when the employee leaves, and cannot be sold, which encourages early exercise.

A harder one

A convertible bond has a face value of 1,000 and a conversion ratio of 20. The share price is 58. Which row gives the conversion price and the conversion value?

  1. Conversion price 50; conversion value 58Why not: Uses the price of a single share as the conversion value instead of the ratio times the share price.
  2. Conversion price 58; conversion value 1,160Why not: Confuses the conversion price (face / ratio) with the current share price.
  3. Conversion price 50; conversion value 1,000Why not: Reports the face value as the conversion value, ignoring that conversion delivers 20 shares at 58.
  4. Conversion price 50; conversion value 1,160 - correct

Conversion price = 1,000 / 20 = 50. Conversion value = 20 x 58 = 1,160. The bond is worth at least the greater of its straight-bond value and this.

The hardest tier

A company has 8 million shares trading at 40, worth 320 million in total. It has 2 million warrants outstanding, each giving the right to buy one share at 30. If all warrants are exercised, the company receives 60 million and issues 2 million new shares. Approximately what is the gain per warrant after allowing for dilution?

  1. 8 - correct
  2. 10Why not: Ignores dilution and uses the pre-exercise price of 40 less the strike of 30.
  3. 2Why not: Allows for the new shares but forgets that the strike proceeds increase the company's value, so the price is 320 / 10 = 32.
  4. 17.50Why not: Divides the new total value (380 million) by the original 8 million shares instead of the 10 million shares outstanding after exercise.

New value = 320 + 60 = 380 million over 10 million shares = 38 per share. Gain per warrant = 38 - 30 = 8, below the undiluted 10.

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