ParT 2: ValuaTION, rISk aNd reTurN
Effectively, the call option that companies retain allows them to shorten the conversion option held by
bondholders. If a company calls its bonds, investors will choose cash if the call price exceeds conversion
value, and they will choose shares if the opposite is true.
Under what circumstances should a company call its convertible bonds? If managers are acting in
the interests of shareholders, they will never call bonds that are worth less than the call price. Doing
so would transfer wealth from shareholders to bondholders. Similarly, if the price of a bond rises above
the call price because the underlying shares have increased in value, then companies should call the
bonds. If companies do not call the bonds and the share price continues to increase, then when investors
ultimately choose to convert their bonds into shares, companies will be selling shares at a bargain. Again,
the result is a transfer of wealth from shareholders to bondholders. Therefore, the optimal policy is to call
the bonds when their market value equals the call price.^1712 How are employee share options different from the options that trade on the exchanges and in
the over-the-counter market?13 What is the most important reason why companies should be required to show an expense on their
income statement for employee share options?14 Suppose a warrant and a call option have the same strike price, the same expiration date and the
same underlying asset. Which is more valuable, the warrant or the call? Why?CONCEPT REVIEW QUESTIONS 8-5
8-5c OTHer OPTION TYPeS
We have focused on financial (especially equity) options in this chapter because these were the first to
be analysed successfully, and the growth of formal markets for financial options since 1973 when the
Chicago exchange was launched and the Black–Scholes formula was published, has been considerable.
We have considered financial options for equities and for bonds. Financial options have also been
developed for foreign currencies and for insurance products.
Suppose, however, we considered the use of options based on non-financial instruments? Here is an
example. Imagine that your company is considering the launch of a new product into the market of your
current customers. You undertake a standard NPV analysis based on the likely cash flows, the expected
horizon for the investment and the appropriate discount rate, all found using the models explained in
earlier chapters. As you are about to finalise your calculations, one of your staff members suggests that
it may be sensible to run a pilot sales program into the market to check to see how your customers may
react to the new product. If, from the pilot, the demand seems strong, then you can launch into the
market with much more confidence – and less risk – than tackling the market blind.17 Actually, this would be the optimal call policy if companies could force investors to choose cash or shares immediately upon receiving the call.
However, because investors in Australia have 30 days to decide whether they want cash or shares, the optimal time to call may be when the
market value of the bonds slightly exceeds the call price. The reason is that if companies call the bonds precisely when the market price hits
the call price, the share price may fall during the 30-day decision period. A decline in the share price would lower the conversion value, and
companies would be forced to redeem the bonds for cash. Allowing the conversion value of the bonds to rise a little beyond the strike price
gives companies a little ‘slack’.