• 1. Who regulates the covered warrant market?
• 2. Who controls the covered warrant market?
• 3. What obligations must market makers fulfil?
• 4. When is the best time to invest in covered warrants?
• 5. How do market makers quote?
• 6. Why did the price of my call covered warrant fall if the price of the underlying rose (or vice versa)?
• 7. When is the best time to exercise a covered warrant?
• 8. How do you exercise a covered warrant?
• 9. What happens to covered warrants in case of extraordinary transactions?
• 10. When is the deadline for exercising a covered warrant?

The Covered Warrant Market (the only covered warrant market active in Italy) is managed and organised by the market management company, in this case, Borsa Italiana spa, a company authorised by Consob pursuant to Article 61 of the Consolidated Law on Finance (Legislative Decree 58/98). The related operating rules are set forth in the market regulations, drawn up by Borsa Italiana and approved by Consob, and in the pertinent instructions.

Specifically, the "Rules of the Markets Organised and Managed by Borsa Italiana" (available on www.borsaitalia.it) establishes both the requirements of covered warrants and their issuers in order for warrants to be admitted to trading, and the methods for trading operations (type of bids which can be issued on the market, how the sale and purchase offers are matched, how contracts are concluded, etc.). The accompanying Instructions to the regulations set forth more detailed provisions illustrating the principles contained in the regulation.

The characteristics of each covered warrant admitted to listing on the market are set directly by the issuer in the "Covered Warrant Regulations", which also defines the specific operating mechanisms, as well as the contractual obligations of the issuer and the subscriber. The "Regulation" are an integral part of the "listing prospectus", which must contain specific information regarding the issuer (balance sheet, income statement, financial position), as well as other information regarding the financial products issued.

All of these documents, but most importantly the prospectus and the regulations, must be read carefully because, as in the case of investment in other financial instruments, investment in covered warrants must begin with complete awareness of how the market you are investing in works, and of the characteristics of the covered warrants you intend to buy.

The Consolidated Law on Finance assigned specific supervisory duties to the market management companies (Borsa Italiana, for the only covered warrant currently operating in Italy). Specifically, in addition to setting forth the market rules, Borsa Italiana must supervise the correct functioning of the market and verify operator, and thus market maker compliance with the regulations set forth in its rules.

Consob has the more general duty of supervising the markets and the market management companies. In this regard, Consob approves and supervises the market rules, in order to ensure transparency, the organised operation of trading, and investor protection. It also supervises the work of market management companies and ascertains violations of insider trading and market manipulation regulations.

The obligations of market makers are set forth by Borsa Italiana, the company that manages the Covered Warrant Market (CWM), in its Rules and accompanying instructions (available on www.borsaitalia.it).

Specifically, issuers undertake, also by assigning such obligations to another intermediary, to continuously display bid and ask prices for amounts equal to at least the minimum trading lot.

When the prices displayed are applied (meaning a contract is concluded with the market maker), the market makers are bound to renew their bid and ask prices within five minutes. Market makers can request to be temporarily exonerated by Borsa Italiana from displaying bid and ask prices.

Market makers must quote a minimum quantity that is at least equal to the minimum trading lot, which is established by Borsa Italiana in the provision for admission to listing of each covered warrant.

Covered warrants are extremely similar to options contracts. Like other derivatives, these contracts carry out the important function of hedging portfolio risk, thus immunising an investment from adverse fluctuations in prices. For example, if you own a share, your investment will be subject to a potential loss in value each time the market prices fall. If you want to limit the potential loss on your investment, by paying a premium, you can attach an out-of-the-money put covered warrant to the share owned.

Covered warrants are used quite often for speculative strategies that do not involve hedging. In this case, covered warrants provide the opportunity to take advantage of financial leverage (higher or lower depending on the maturity and strike price), as they have a higher level of reactivity compared to the underlying security. However, the use of covered warrants as more speculative substitutes for the underlying securities often leads to losses, sometimes of the total investment.

Market makers usually quote in volatility terms. When they must display their prices, they calculate the bid and ask prices of their covered warrants starting from the volatility of the underlying security. For this purpose, market makers use automatic quoting systems which, upon inputting the volatility, use the pricing model to calculate the bid and ask prices of their covered warrants. Generally, these computerised systems also automatically update the quotes upon changes in the underlying security.

Thus, when they sell their and buy covered warrants, market makers are effectively selling and buying volatility. The listed volatility represents the market maker's forecast of the future volatility of the underlying security. To execute this forecast, market makers take as a reference the implicit volatility of the prices of analogous derivatives listed on other regulated markets (for example, for Italian shares and MIB30 shares, a good reference is given by the implicit volatility of options on individual securities and MIBO30 options traded on the IDEM) or on unregulated markets (Over the Counter markets).

Considering that the implicit volatility expressed by prices on "professional" markets, which refer to very high numbers of instruments (making these market more difficult for investors to access), covered warrant market makers apply a volatility mark-up, in order to compensate the "retail sale" of "wholesale" volatility on professional markets.

However, each market maker has a different pricing policy, and offers its covered warrants at prices that incorporate higher or lower implicit volatility values. For this reason, the choice of issuer must start from the comparison of the volatility offered on covered warrants with similar characteristics (underlying security, strike price and maturity).

As mentioned above, the trend in the price of a covered warrant is affected by a significant number of factors. The combination of these factors may result in an unexpected trend in the covered warrant prices compared to the underlying asset. For example, it often happens that an increase in prices of the underlying security does not result in the increase in the prices of call covered warrants, but a substantial stability or even a decrease. This is often due to the presence of a decreasing trend in the volatility of the underlying security. In addition, with all other factors remaining the same (price of the underlying and volatility), a price decrease may be observed in the covered warrant due to the time factor which, as stated, negatively affects the value of the covered warrant.

Assessing whether to invest in covered warrants, instead of any other financial investment depends on the investor’s personal expectations and propensity towards risk. The investor must establish the levels of risk he is willing to undergo and the levels of profit at which to settle his investment. When investing in covered warrants, it is important that the investor remain continuously updated on the performance of the warrant and the underlying, as changes in the price of the covered warrant may be sudden and significant in size.

One an investor has decided to disinvest his covered warrants, he has two alternatives: exercise the warrants or sell them on the market. The cost-effectiveness of the two alternatives depends on the comparison between the intrinsic value and the market price. If the first is greater than the second, it is better to exercise the warrant. In the opposite situation, it is better to sell the warrant on the market.

Lastly, if the investor decides to wait until maturity, and the warrant involves cash settlement, it is important to consider the possibility that on the maturity date the price of the underlying might exhibit irregular behaviour. This is due to the fact that the market maker-issuer may have the need to operate on the underlying security’s market as a result of technical requirements linked to its risk management, with effects on the price of the underlying (and consequently, on the warrant price) which could move in an unfavourable direction for the investor. Thus it is important to decide whether to accept the risk of these possible, unpredictable fluctuations, or not to wait for the maturity date and to sell the warrant or, if more profitable, to exercise the right near the maturity date.

To exercise an American-style covered warrant, during the life of the warrant, it is generally necessary to communicate to the issuer, through your intermediary, your intention to exercise the warrant, for a number of covered warrants equal to at least the minimum exercise lot set forth in the warrant regulations. The regulations also establish the specific methods to be followed for exercise. It is a good general rule, then, to carefully read the regulations (which are also contained in the listing prospectus), and to provide your intermediary with the necessary instructions, also considering the time required for the issuer to receive the notification of exercise. Generally, the covered warrant is effectively exercised on the day following that on which the issuer receives the notification. Thus, conditions may have changed, and with this, the cost-effectiveness for the investor.

Once the warrant has reached maturity, the Rules of Borsa Italiana requires that the warrant be automatically exercised: bearers of covered warrants which are in-the-money upon maturity automatically receive cash settlement, unless they expressly waive such settlement (exercise by exception) when, for example, fees linked to the payment of the amount owed are greater than the earnings. This automatic procedure was set forth in order to protect investors who, while they are bearers of in-the-money covered warrants, forget to request exercise upon maturity, thereby losing their right to collect the amount of money from the issuer.

In case of extraordinary financial transactions on securities underlying covered warrants (such as splitting or regrouping of shares, share capital increases, merger or split-off of companies, conversion of shares or distribution of extraordinary dividends), in order to ensure that such transactions have no effect on the economic value of the investment, it is necessary to carry out suitable adjustment procedures.

These adjustments are carried out, according to commonly accepted methods, by the issuers, who intervene on the characteristics of their covered warrants in various ways, for example, by modifying the strike price and the cover ratio of the covered warrants or substituting the underlying security. The specific adjustment that the issuer intends to adopt must be communicated to Borsa Italiana with suitable advance notice, so that it may promptly inform the market. Thus, the investor must keep constantly updated on the events regarding the underlying securities of the covered warrants held, and remain informed, also by directly asking the issuer, on the adjustments that the issuer intends to adopt, as well as the timing of such adjustments.

Covered warrants can be traded on the market up to approximately one week prior to their maturity. Specifically, Borsa Italiana cancels covered warrants from listing two stock market trading days prior to the last valid day for their exercise. As the methods of exercise are established by the issuer in the warrant regulations and the listing prospectus, it is important to always consult these documents to check the timing provided for exercise of the warrants.