Deck 16: Capital Market Financing: Hybrid and Other Securities

Question 1

A convertible debenture can never sell for more than its conversion value or less than its bond value.

Answer 1

False

Question 2

A security made up of corporate loans and credit default swaps is called a collateralized debt obligation (CDO).

Answer 2

True

Question 3

Firms generally do not call their convertibles unless the conversion value is greater than the call price.

Answer 3

True

Question 4

The Bank of Canada is the primary guarantor of securitized assets in Canada.

Question 5

Securitization can always improve the liquidity with respect to the securitized assets.

Question 6

Liquid assets such as bankers' acceptance (BA) can never be used for securitization.

Question 7

One warrant entitles the holder to purchase only common share.

Question 8

The design of stepped-up exercise prices is to control the timing of equity capital raised for the firm.

Question 9

Convertible bonds typically have the characteristic of being subordinated debentures.

Question 10

The "misused" asset securitizations, credit derivatives, and CDOs took the blame of creating the credit crisis of 2007.

Question 11

Credit default swaps help protection sellers transfer all interest rate risk to the protection buyers.

Question 12

Most convertible securities are bonds or preferred stocks that, under specified terms and conditions, can be exchanged for common stock at the option of the holder.

Question 13

The problem of dilution of stockholders' earnings never results from the sale of call options, but it can arise if warrants are used.

Question 14

The value of the warrant drops every time when the underlying shares pay cash dividends.

Question 15

The owner of a convertible bond owns, in effect, both a bond and a call option.

Question 16

Convertible bonds usually have higher credit ratings than the basic non-convertible bonds.

Question 17

A warrant is an option, and as such it cannot be used as a "sweetener."

Question 18

A warrant holder is not entitled to vote, but he or she does receive any cash dividends paid on the underlying stock.

Question 19

A detachable warrant is a warrant that can be detached and traded separately from the security with which it was issued. Most traded warrants are originally attached to bonds or preferred stocks.

Question 20

Asset securitizations allow investors to expand the scope of their investment choices.

Question 21

Which of the following statements best describes warrants?

A) Warrants are long-term put options that have value because holders can sell the firm's common stock at the exercise price regardless of how low the market price drops.
B) Warrants are long-term call options that have value because holders can buy the firm's common stock at the exercise price regardless of how high the stock's price has risen.
C) A firm's investors would generally prefer to see it issue bonds with warrants than straight bonds because the warrants dilute the value of new shareholders, and that value is transferred to existing shareholders.
D) A drawback to using warrants is that if the firm is very successful, investors will be less likely to exercise the warrants, and this will deprive the firm of receiving any new capital.

Question 22

If the expected recovery values decreases, then the size of payment upon the occurrence of a credit event will increase. This will increase the protection payment.

Question 23

The conversion price of a convertible security is fixed and independent of stock market conditions.

Question 24

Asset-backed commercial papers do not appeal to investors because little is known about the assets backing the securities.

Question 25

Which of the following statements best describes convertibles?

A) One advantage of convertibles over warrants is that the issuer receives additional cash when convertibles are converted.
B) Investors are willing to accept a lower interest rate on a convertible than on otherwise similar straight debt because convertibles are less risky than straight debt.
C) At the time it is issued, a convertible's conversion(or exercise) price is generally set equal to or below the underlying stock's price.
D) For equilibrium to exist, the expected return on a convertible bond must normally be between the expected return on the firm's otherwise similar straight debt and the expected return on its common stock.

Question 26

Special purpose vehicles (SPVs) in asset securitization usually contain credit enhancements for their securities.

Question 27

Why is asset securitization is advantageous to investors?

A) It removes all risk of holding the assets.
B) It results in higher returns.
C) It increases investment choices.
D) It eliminates the need for financing.

Question 28

Which of the following is true when warrants are exercised?

A) The security associated with the warrant drops in value depending on the exercise price of the warrant.
B) Funds are transferred from the retained earnings account to common shares account for the market value of the shares.
C) The number of common shares outstanding changes.
D) There is no new capital for the firm because the warrants are exchanged for the common shares.

Question 29

In many loan securitizations, most borrowers of the sold loans are unaware that the lender has sold the loans.

Question 30

The ultimate credit risk of asset-backed securities lies with the special purpose vehicle that is the central payor.

Question 31

Different tranches in a mortgage-backed security have different default risk exposure.

Question 32

How does home mortgage securitization benefit mortgage originators?

A) They can improve the asset liquidity.
B) They have additional funds for other investment.
C) They are free from default and prepayment risks.
D) They can improve asset liquidity, have additional funds for other investments, and are free from default and prepayment risks.

Question 33

Warrants, convertible securities, and call and put options are similar in the sense that they have a value contingent upon the future value of the firm's shares.

Question 34

Which of the following is true regarding a collateralized debt obligation (CDO)?

A) A security has no default risk exposure.
B) A security is tax free.
C) A security involves a credit default swap.
D) A security represents a claim on the cash flows of a loan.

Question 35

Which of the following factors will NOT affect the price paid on warrants?

A) the coupon rates of the security to which the warrant is issued
B) the expiration time of the warrant
C) the difference between the current share price and the exercise price on warrants
D) the amount of cash dividends paid on the common shares of the firm

Question 36

Which of the following statements best describes warrents?

A) One important difference between warrants and convertibles is that convertibles bring in additional funds when they are converted, but exercising warrants does not bring in any additional funds.
B) The coupon rate on convertible debt is normally set below the coupon rate that would be set on otherwise similar straight debt even though investing in convertibles is more risky than investing in straight debt.
C) The value of a warrant to buy a safe, stable stock should exceed the value of a warrant to buy a risky, volatile stock, other things held constant.
D) Warrants can sometimes be detached and traded separately from the debt with which they were issued, but this is unusual.

Question 37

Who or what is (are) the legal asset owner behind the home mortgage securitization?

A) special purpose vehicle (SPV)
B) individual investors
C) banks that originate the mortgages
D) Canada Mortgage and Housing Corporation (CMHC)

Question 38

Which of the following assets cannot be used for securitization?

A) credit card receivables
B) student loans
C) accrued fees
D) home mortgages

Question 39

Since warrants and convertibles give holders the right to exchange for their underlying stock, they should represent the same sources of financing.

Question 40

If a zero correlation of default exists between the different securities and the loan, the equity tranche may have no hope of being paid.

Question 41

The ABC Bank enters into a credit default swap with XYZ Financial. The notional amount of the swap is $50 million. The 5-year swap is based upon a 5-year loan to LMN Corp. The size of the protection payment is 3% per year. As LMN bankrupts during the time this swap is still valid, XYZ has paid ABC $22.5 million for settlements. What is the recovery ratio on the underlying loan?

A) 60%
B) 55%
C) 45%
D) 40%

Question 42

What is the theoretical value of a warrant when the current price of the stock is $50 and the exercise price is $45? The exchange ratio is four shares for each warrant.

A) $20
B) $15
C) $10
D) $5

Question 43

The following data apply to Saunders Corporation's convertible bonds:
What is the bond's conversion value?

A) $734.89
B) $773.57
C) $814.29
D) $857.14

Question 44

The following data apply to Saunders Corporation's convertible bonds:
What is the bond's straight-debt value?

A) $684.78
B) $720.82
C) $758.76
D) $798.70

Question 45

Chocolate Factory's convertible debentures were issued at their $1,000 par value in 2007. At any time prior to maturity on February 1, 2027, a debenture holder can exchange a bond for 25 shares of common stock. What is the conversion price, Pc?

A) $40.00
B) $42.00
C) $44.10
D) $46.31

Question 46

The ABC Bank enters a credit default swap of $10 million for 5 years with the XYZ Insurance. How much ABC has to pay with a premium rate of 2.5% per year?

A) $100,000
B) $150,000
C) $250,000
D) $500,000

Question 47

What is the fully diluted EPS?

A) $1.57
B) $1.59
C) $1.62
D) $1.71

Question 48

Based on your answers to the three preceding questions, what is the minimum price (or "floor" price) at which the Saunders bonds should sell?

A) $734.89
B) $773.57
C) $814.29
D) $857.14

Question 49

The following data apply to Saunders Corporation's convertible bonds:
What is the bond's conversion ratio?

A) 27.14
B) 28.57
C) 30.00
D) 31.50

Question 50

Which of the following variables will decrease the protection payment for credit default swaps?

A) The expected recovery values decrease.
B) The expected risk of default decrease.
C) The unexpected increase of borrowing from the underlying company.
D) The unexpected drop in share prices of the underlying company.

Question 51

The ABC Bank enters into a credit default swap with XYZ Financial. The swap runs for 5 years and is based upon a term loan to LMN Corp. The size of the protection payment is 5% per year. Unfortunately, LMN goes bankrupt a year after when this swap agreement becomes effective. Even with a 75% recovery value on the underlying loan, XYZ has paid ABC $20 million for settlements. How much has ABC lent to LMN?

A) $100 million
B) $80 million
C) $50 million
D) $20 million

Question 52

A convertible bond has a call price of $1,100. Its underlying stock is selling at $70 per share, and the conversion price is $50. If owners of the convertible bond convert and sell the stock, what is the profit or loss on each bond if the convertible is called by the company?

A) -$100
B) -$200
C) -$300
D) +$300

Question 53

Warren Corporation's stock sells for $42 per share. The company wants to sell some 20-year, annual interest, $1,000 par value bonds. Each bond would have 75 warrants attached to it, each exercisable into one share of stock at an exercise price of $47. The firm's straight bonds yield 10%. Each warrant is expected to have a market value of $2.00 given that the stock sells for $42. What coupon interest rate must the company set on the bonds in order to sell the bonds-with-warrants at par?

A) 7.83%
B) 8.24%
C) 8.65%
D) 9.08%

Question 54

How much is the firm's total earnings after conversion?

A) $1.71 million
B) $2.04 million
C) $2.40 million
D) $3.17 million

Question 55

Orient Airlines' common stock currently sells for $33, and its 8% convertible debentures (issued at par, or $1,000) sell for $850. Each debenture can be converted into 25 shares of common stock at any time before 2017. What is the conversion value of the bond?

A) $707.33
B) $744.56
C) $783.75
D) $825.00

Question 56

Valdes Enterprises is considering issuing a 10-year convertible bond that would be priced at its $1,000 par value. The bonds would have an 8.00% annual coupon, and each bond could be converted into 20 shares of common stock. The required rate of return on an otherwise similar nonconvertible bond is 10.00%. The stock currently sells for $40.00 a share, has an expected dividend in the coming year of
$2)00, and has an expected constant growth rate of 5.00%. What is the estimated floor price of the convertible at the end of Year 3?

A) $794.01
B) $835.81
C) $879.80
D) $926.10

Question 57

You have paid $5 to buy a warrant with an exercise price of $40. The stock is currently trading at $50. How much profit or loss would you make by exercising the warrant if one warrant entitles the owner to buy one share of stock?

A) $5.00
B) $10.00
C) $40.00
D) $50.00

Question 58

Upstate Water Company just sold a bond with 50 warrants attached. The bonds have a 20-year maturity and an annual coupon of 12%, and they were issued at their $1,000 par value. The current yield on similar straight bonds is 15%. What is the implied value of each warrant?

A) $3.76
B) $3.94
C) $4.14
D) $4.35

Question 59

Curry Corporation is setting the terms on a new issue of bonds with warrants. The bonds will have a 30-year maturity and annual interest payments. Each bond will come with 20 warrants that give the holder the right to purchase one share of stock per warrant. The investment bankers estimate that each warrant will have a value of $10.00. A similar straight-debt issue would require a 10% coupon. What coupon rate should be set on the bonds-with-warrants so that the package would sell for $1,000?

A) 6.75%
B) 7.11%
C) 7.48%
D) 7.88%