Poison Pills, Zero Cost Calls and Underwriting Put Options - The Mystery of it All!
Team Latte
Feb 25, 2005

A few days ago it was reported in the international press that a leading mainland Chinese internet portal Sina group was contemplating a Poison pill strategy to ward off a hostile takeover from another mainland Chinese company, game maker Shanda Group. This apparently was interesting and possibly amusing because it was for the first time that Poison pill strategy was being employed in China or even greater China.

Poison Pills refer to tactics by a company designed to avoid a hostile takeover. One example is the issuance of preferred stock that gives shareholders the right to redeem their shares at a premium after the takeover. The other, more common approach is the issuance of an underwritten rights issue. A rights issue and an underwritten rights issue has embedded call and put options which are building block of financial derivative securities.

An analysis of the underwritten rights issue reveals some strange dynamics and only confirms the general belief that derivatives are truly mysterious.

A Rights Issue is when a company offers new shares to its existing shareholders usually at a discount to the market price. Companies who already trade on the Stock Exchange issue entitlement shares to raise additional equity (money). In a rights issue, shares are offered to existing shareholders in proportion to their holdings and the reason why share price offered is usually lower than the price of the existing shares in the market is to encourage shareholders to purchase them.

A Rights issue can be looked exactly as a warrant issue and rights can be priced as warrants. A warrant is essentially a call option adjusted for dilution and a rights issue can also be looked upon as a call option on the un-issued shares of the company whereby the company is the seller of the call option and the existing shareholders are the buyers of the call option.

But an interesting thing to note is that these call options are sold for free. In other words, in a rights issue the shareholders are buying the call options from the company for zero consideration. Is it then a totally "free lunch"? Can any single, basic derivative instrument be totally zero cost?

Further, almost always in a takeover or a poison pill strategy the company gets the rights issue underwritten by an underwriter, usually an investment bank. In an underwritten the company buys and the underwriter sells put options on the shares offered to the shareholders. Now underwriter for a fixed fee agrees to acquire all new shares that are not applied for by the close of the offer. There are two points to note about this underwriting put option as shown below:

1. The underwriter's fee should theoretically be equal to the value (read cost) of the underwriting put option. And that should be his gain exactly like a seller of a put option. If the underwriting fee is much higher than the cost of the underwriting put option then the he is making an abnormal profit; however, since an underwriting put option is not a vanilla option (see point 2 below) the premium charged by the underwriter should be higher;
2. The premium of the underwriting put option - the underwriter's fee - is paid from the proceeds of the new issue of shares vide the rights granted to the shareholders and therefore it can be viewed as a deferred premium option or a variation of contingent premium option; The premium for a deferred premium or contingent premium option is higher than a vanilla option;

Thus in an underwritten rights issue a company is buying a put option - an exotic put option - from the underwriter and selling a vanilla call option to the shareholders. But the put is sold for a price and the call is sold for free and the price of the put is netted against the exercise value of the calls.

A few questions regarding the above trade remains intriguing:

• The strike price of both the calls and puts are the same and the call is in the money and the put is out of the money; this is because the company will offer shares to the existing shareholders (rights) at a price below the market traded price to entice them to exercise the rights and buy the shares which will make the calls in the money and the puts out of the money;
• We can value the call options as vanilla option and employ Black-Scholes model to price them; and then value the warrants. The rights are actually call warrants and not simple options. But if the company is selling call options for free - apparently at least - then who is paying for them?
• How do we value the underwriter's put option on the un-issued shares? Though the premium is deferred, can we simply value it in a put-call parity relationship given the value of the call option?
• Is the company, by selling a call for free and buy a put for a price taking on unusual risks? Are the existing shareholders getting a free ride in this trade?
• Or is the underwriter taking on an unusual risk by selling an out of the money put? Though the put is out of the money if the deal for some reason fails - the existing shareholders don't exercise their rights - and the stock price tanks then the underwriter could experience substantial loss. In other words, the underwriter should have a very good estimate of the underlying volatility of the stock.

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