As you will need to know for the Series 7, some securities fall outside the boundaries of the more normal common and preferred stock, but they still involve ownership in a company or the opportunity to get it. These special securities include American Depositary Receipts, a right to buy new shares at a discount, and warrants.
American Depositary Receipts (ADRs)
American Depositary Receipts (ADRs) are receipts for foreign securities traded in the United States. ADRs are negotiable certificates (they can be sold or transferred to another party) that represent a specific number of shares (usually one to ten) of a foreign stock. ADR investors may or may not have voting privileges. U.S. banks issue them; therefore, investors receive dividends in U.S. dollars.
The stock certificates are held in a foreign branch of a U.S. bank. To exchange their ADRs for the actual shares, investors return the ADRs to the bank holding the shares. In addition to the risks associated with stock ownership in general, ADR owners are subject to currency risk (decline in the value of the security because the currency value of the issuing corporation falls in relation to the dollar).
The right to buy new shares at a discount
Corporations offer rights (subscription or preemptive rights) to their common stockholders. To maintain their proportionate ownership of the corporation, rights allow existing stockholders to purchase new shares of the corporation at a discount directly from the issuer, before the shares are offered to the public. Stockholders receive one right for each share owned.
The rights are short-term (usually 30 to 45 days). The rights are marketable and may be sold by the stockholders to other investors. If existing stockholders don’t purchase all the shares, the issuer offers any unsold shares to a standby underwriter. A standby underwriter is a broker-dealer that purchases any stock that wasn’t sold in the rights offering and then resells the shares to other investors.
For the Series 7, you can assume that common stockholders automatically receive rights.
Because rights allow investors to purchase the shares at a discount, rights have a theoretical value. The board of directors determines that value when they decide how many rights investors need to purchase a share, as well as the discounted price offered to investors. To determine the value of a right, you can use one of two basic formulas: the cum rights formula or the ex-rights formula.
The cum rights formula
You may have to find the value of a right while shares are still trading with rights attached. To find out how much of a discount each right provides, you can simply take the difference between the market price and the subscription price, divide that by the number of rights, and come up with a nice, round number.
But not so fast! On the ex-date (the first day the stock trades without rights), the market price will drop by the value of the right. Before the ex-date, you can find the value of a right by using the cum (Latin for with) rights formula:
The +1 in the denominator accounts for the later drop in the market price. Try out the following rights question.
DEF Corp. is issuing new shares through a rights offering. If a new share costs $16 plus four rights and the stock trades at $20, what is the theoretical value of a right prior to the ex-date?
(A) $0.20
(B) $0.80
(C) $1.00
(D) $1.20
The right answer is Choice (B). The stock is trading with (cum) rights (the words prior to the ex-date in the problem tip you off), so you need to use the cum rights formula to figure out the value of a right:
The theoretical value of a right is $0.80.
The ex-rights formula
When you calculate the value of a right on the ex-date (the first day the stock trades without rights), the market price has already fallen by the value of the right. You simply have to use the new market price and the subscription price to figure out the discount per right. If the stock is trading ex-rights, use the following formula to figure out the value of a right:
The cum rights and ex-rights formulas are the same except for the +1 in the denominator. Because ex means without, remember that the ex formula is without the +1.
Warrants: The right to buy stock at a fixed price
Warrants are certificates that entitle the holder to buy a specific amount of stock at a fixed price; they’re usually issued along with a new bond or stock offering. Warrant holders have no voting rights and receive no dividends. Bundled bonds and warrants or bundled stock and warrants are called units. They are long term and sometimes perpetual (without an expiration date).
Warrants are sweeteners because they’re something that the issuer throws into the new offering to make the deal more appealing; however, warrants can also be sold separately on the market. When warrants are originally issued, the warrant’s exercise price is set well above the underlying stock’s market price.
For example, suppose QRS warrants give investors the right to buy QRS common stock at $20 per share when QRS common stock is trading at $12. Certainly, exercising their warrants to purchase QRS stock at $20 wouldn’t make sense for investors when they can buy QRS stock in the market at $12. However, if QRS rises above $20 per share, holders of warrants can exercise their warrants.