Rights, Warrants, and Convertibles

Rights

A subscription right is a short-lived privilege distributed to existing shareholders that lets them buy newly issued shares at a subscription price below the current market price. It exists to honour the preemptive right: a shareholder who exercises maintains their proportional ownership rather than being diluted by the new issue.

The characteristic terms are consistent. One right is distributed per share owned. The subscription price is set below the market price, so the right has intrinsic value on day one. The life is short — typically thirty to forty-five days. Rights are transferable and trade in the secondary market, so a shareholder who does not want to subscribe can sell them rather than let them expire worthless. Exercising several rights is usually required to buy one new share, and the offering document states how many.

Because the right has value, the stock's price adjusts when it detaches. While the stock still carries the right it trades cum rights; once it no longer does, it trades ex rights, and the price falls by roughly the value of the right.

The two formulas, where M is the market price of the stock, S is the subscription price and N is the number of rights required to buy one share:

Cum rights: value of one right equals (M minus S) divided by (N plus 1).

Ex rights: value of one right equals (M minus S) divided by N.

The plus one in the cum-rights version is there because the cum-rights market price still includes the value of the right attached to the share. Worked example: stock at $44, subscription price $38, four rights needed per share. Cum rights, a right is worth (44 minus 38) divided by 5, which is $1.20. Ex rights, with the stock now trading around $42.80, a right is worth (42.80 minus 38) divided by 4, which is $1.20 again. The two formulas agree, which is the point of the plus one.

Warrants

A warrant is a long-term instrument giving the holder the right to buy stock from the issuer at a fixed exercise price. The differences from a right are systematic and worth learning as a table you can reconstruct.

Term: a right lives weeks; a warrant lives years, sometimes five or ten, occasionally in perpetuity.

Price at issue: a right's subscription price is below the market, so a right has intrinsic value immediately. A warrant's exercise price is above the market at issue, so a warrant begins with no intrinsic value at all — only time value. It becomes valuable if the stock rises past the exercise price.

Origin: rights are distributed to existing shareholders as a preemptive matter. Warrants are typically attached to a bond or preferred issue as a sweetener, to let the issuer pay a lower coupon on the debt. Once detached, the warrant trades separately.

Neither instrument pays a dividend or carries a vote — they are claims on stock, not stock. And both are issued by the company itself, which distinguishes them from listed call options, which are created by market participants and cleared by the OCC. Exercising a warrant creates new shares and dilutes existing holders; exercising a call option does not.

Convertible securities and parity

A convertible bond or convertible preferred may be exchanged by the holder for common stock at a stated conversion price. The arithmetic runs from par.

Conversion ratio equals par value divided by conversion price. A $1,000 bond convertible at $40 has a ratio of 25 shares. A $100 par preferred convertible at $25 has a ratio of 4 shares.

Parity price of the stock is the bond's market price divided by the conversion ratio — the stock price at which the two are worth the same. A bond trading at $1,100 with a ratio of 25 has a parity stock price of $44.

Parity price of the bond is the stock price times the conversion ratio. With the stock at $46 and a ratio of 25, the bond's parity is $1,150; a bond trading below that is theoretically cheap and invites arbitrage.

The standard exam manoeuvre is to give you a conversion price and a stock price and ask whether conversion is profitable. Work it in three steps every time: ratio first, then parity, then compare with the market price of the security you hold. Doing it in a different order is how people get it backwards under time pressure.

The economics are the same as for convertible preferred. The conversion privilege has value to the holder, so the issuer pays a lower coupon than it would on a straight bond of the same credit. The holder accepts less income in exchange for equity upside. Convertible bondholders retain creditor status until they convert, which places them above every shareholder in liquidation — the reason a convertible bond is sometimes described as a bond with an equity option rather than as equity.

A forced conversion is worth recognising: an issuer calls a convertible when the parity value of the stock exceeds the call price, which makes conversion the rational choice for holders and eliminates the debt from the balance sheet.

Anti-dilution

Every one of these instruments carries a claim expressed in a fixed number of shares at a fixed price, and every one of them is therefore vulnerable to the issuer changing what a share means. If a company with a convertible bond at a $40 conversion price does a two-for-one split, an unadjusted conversion privilege would be worth half what it was.

An anti-dilution provision adjusts the conversion price, the conversion ratio, or the warrant's exercise price and share count when the issuer splits its stock, pays a stock dividend, or otherwise changes the share count. After a two-for-one split, the $40 conversion price becomes $20 and the ratio doubles from 25 to 50 shares. The economics are preserved.

Note what anti-dilution does not protect against: a straightforward new issue of shares for cash at market price, which dilutes proportional ownership but not the value of the conversion privilege. That is what the preemptive right and its subscription rights exist for, which closes the loop back to the start of this lesson.