Preferred Stock, Rights, and Warrants
About This Lesson
Preferred stock, rights, and warrants round out the equity world beyond plain common stock, and the exam tests each one in predictable ways. By the end of this chapter you will know what makes preferred stock a hybrid security, the differences among its types, how rights and warrants work, and how an ADR lets a U.S. investor own a foreign company.
What you'll cover
- preferred stock as a hybrid, and the cumulative, participating, convertible, and callable types
- rights versus warrants, and the rights-offering math
- American Depositary Receipts and the currency risk they carry
This is the second chapter of the products module.
Preferred Stock
Preferred stock is a hybrid security, sitting partway between a stock and a bond. Like a bondholder, a preferred shareholder collects a fixed dividend, and that dividend has to be paid before common stockholders see a penny. But like a stock, it represents equity in the company rather than debt. The features the exam looks for:
- a fixed dividend, stated either as a dollar amount or as a percentage of par;
- priority over common stock in both dividends and liquidation;
- generally no voting rights (the usual trade-off for the steadier income);
- less price volatility than common stock, since its value tracks its fixed dividend more than the company's growth;
- several flavors, the main ones being cumulative, participating, callable, and convertible.
Cumulative preferred
If the company skips a dividend on cumulative preferred, the missed payments do not vanish; they pile up as dividends in arrears. Every cent of those arrears must be paid to the cumulative preferred holders before common stockholders can receive any dividend. This is the most common and the most protective type. For example, a cumulative preferred paying $4 a year that skips two years owes $8 in arrears plus the current $4, so $12 per share must go out before any common dividend resumes.
Participating preferred
Participating preferred collects its stated dividend and gets to share in additional dividends alongside common shareholders. It is fairly rare, which is exactly why the exam likes to test it.
Convertible preferred
Convertible preferred can be exchanged for a fixed number of common shares at a preset conversion ratio, which is just the par value divided by the conversion price. A $100 par preferred with a $25 conversion price converts into four common shares (100 ÷ 25). The parity price is the point at which the preferred and the common shares it would convert into are worth the same amount.
Callable preferred
Callable preferred lets the issuer buy the shares back at a set price after a certain date, usually once rates have fallen and the company would rather reissue at a lower dividend. Because the call feature favors the issuer, callable preferred typically pays a slightly higher dividend to compensate holders for that risk.
- Missed dividends accumulate as dividends in arrears
- All arrears paid before any common dividends
- Most common and most investor-protective type
- SIE exam math: arrears × years + current year
- Missed dividends are permanently forfeited
- No arrears accumulate, each period starts fresh
- Higher risk to investor than cumulative
- Rare in practice because investors prefer cumulative
- Receives stated dividend plus shares in additional earnings
- Participates alongside common shareholders in extra dividends
- Rare but heavily tested, unusual hybrid
- Can be cumulative AND participating simultaneously
- Converts to common shares at a set conversion ratio
- Ratio = par value ÷ conversion price
- Lower stated dividend than comparable non-convertible
- Parity price = preferred market price ÷ conversion ratio
Calculate conversion ratios, parity prices, and premiums for convertible securities.
Which of the following is typically a feature of preferred stock but NOT common stock?
A cumulative preferred stock with a $5 annual dividend has not paid dividends for 3 years. Before the company can pay common stock dividends, it must first pay preferred holders:
A convertible preferred stock has a $100 par value and a conversion price of $25 per share. If the common stock is currently trading at $30, what is the parity price of the preferred stock?
Which type of preferred stock would be MOST protective for an investor if the company skips dividend payments for two years?
Rights & Warrants
Both rights and warrants give someone the ability to buy stock at a set price, but they are aimed at different people and work on very different timelines.
Rights
Rights (subscription rights, tied to the preemptive right) are short-term, usually lasting only about 30 to 60 days. A company hands them to its existing shareholders during a new-share offering so those shareholders can buy enough new stock to keep their proportional ownership and avoid being diluted. The exercise price is set below the current market price, which is what makes a right worth using.
Warrants
Warrants run on the opposite timeline: they are long-term, often lasting years. Rather than protecting existing owners, warrants are usually included as a sweetener on a bond or preferred stock offering to make the deal more attractive. Their exercise price is typically set above the market price at issuance, so they only pay off if the stock climbs over time.
Rights have measurable value, and the SIE will sometimes ask you to compute it. The formula depends on whether the stock is still trading cum rights (with the right attached) or ex rights (after it has detached):
- Cum-rights value = (market price − subscription price) ÷ (number of rights needed + 1)
- Ex-rights value = (market price − subscription price) ÷ number of rights needed
For example, take a stock trading at $50 with a $40 subscription price, where it takes 5 rights to buy one new share. Cum-rights, a right is worth ($50 − $40) ÷ (5 + 1) = $1.67. Once the stock goes ex-rights, its price drops by that value to about $48.33, and the right is worth ($48.33 − $40) ÷ 5 = $1.67, the same amount.
One warning the exam likes: rights that are neither exercised nor sold simply expire worthless. A shareholder who ignores a rights offering is effectively letting themselves be diluted.
These are often tested together because both involve the right to buy stock at a fixed price:
Rights: Short-term (typically 30–60 days). Issued to existing shareholders to let them maintain their proportional ownership when new shares are issued. Exercise price is below the current market price (otherwise no one would use them).
Warrants: Long-term (months to years, sometimes perpetual). Issued to investors as a sweetener on bond or preferred stock offerings to make them more attractive. Exercise price is above the current market price at issuance (they are incentive for future growth).
Both rights and warrants trade separately in the secondary market after issuance.
American Depositary Receipts
An American Depositary Receipt (ADR) is the standard way a U.S. investor buys into a foreign company without dealing in a foreign market. A U.S. depositary bank holds the actual foreign shares and issues ADRs that trade on U.S. exchanges and settle in U.S. dollars, so to the investor they behave much like a domestic stock. The catch is currency risk: because the underlying shares are priced in a foreign currency, exchange-rate swings affect the ADR's value even when the foreign stock itself has not moved.
• Sponsored ADRs = the foreign company participates in the issuance. Typically listed on major exchanges (NYSE, Nasdaq). Financial reporting to the SEC required.
• Unsponsored ADRs = created by a depositary bank without the company's involvement. Trade OTC. Less regulatory oversight.
• ADR holders receive dividends in U.S. dollars, but the actual dividend amount fluctuates with the exchange rate.
• Currency risk is the primary additional risk versus domestic stocks, even if the stock price is stable in the local currency, exchange rate movements affect the ADR's value.
Chapter Essentials
Preferred stock is a hybrid: a fixed dividend that ranks ahead of common, priority in liquidation, and usually no vote. The types are the heart of the exam, cumulative (missed dividends pile up as arrears and must be cleared before any common dividend, making it the most protective), participating (stated dividend plus a share of more), convertible (swaps into common at par ÷ conversion price), and callable (the issuer can buy it back).
Rights are short-term, go to existing shareholders, and are priced below market to fight dilution; warrants are long-term sweeteners priced above market at issue. And an ADR lets a U.S. investor hold a foreign company in dollars, carrying currency risk on top of the usual stock risk.
The reliable gotchas in this chapter:
• Cumulative preferred is the most protective. Skipped dividends accumulate as arrears, and every cent of arrears must be paid before common stockholders get anything. A question about which preferred best protects an investor when dividends are skipped is pointing to cumulative.
• Conversion ratio is par divided by the conversion price. A $100 par convertible with a $25 conversion price converts into four shares, not 25. Watch which number is the denominator.
• Rights versus warrants comes down to term and price. Rights are short-term, go to existing shareholders, and are priced below market. Warrants are long-term sweeteners priced above market at issue.
• Preferred stock generally has no vote. The fixed, priority dividend is the trade-off for giving up the voting rights common stockholders have.
• An ADR's main extra risk is currency. It trades and pays dividends in dollars, but the underlying shares are in a foreign currency, so exchange-rate moves affect its value even if the foreign stock is flat.
• Unexercised rights expire worthless. Ignoring a rights offering does not keep you whole, it dilutes your ownership.
Test yourself with exam-style questions on this topic.