The traditional concept of bonds is based on a simple financial scheme: the subscriber of the security deposits with the issuer an amount of money which accrues interest and which will be returned at a set maturity date. Interest may be paid periodically, over the life of the security, or at the maturity date (zero coupon bond), and the amount of interest may be fixed (fixed rate bond) or float in relation to the performance of market interest rates (floating rate bond). In any event, the criteria for determining interest is established upon subscription, and the application of interest is not complicated.

In the mid-90’s, new types of bonds appeared on the market, as alternatives to government bonds and certificates of deposit. These new bonds have been identified as structured, and are generally issued by banks. The common characteristic of structured bonds is the use of unusual, innovative methods for calculating the coupon or redemption value, which may be very complex.

These difficult elements ensure that understanding the characteristics of the security and thus, of its cost-effectiveness is no simple process, and is unlikely to be immediately understood by investors. On the contrary, these securities are also objectively difficult to value.

There are various types of bonds in the category of structured bonds. Some of these maintain the typical feature of bonds, meaning the return of the capital invested, but have varying levels of complexity for calculating interest. Examples of this type are bonds whose yield is uncertain, as it is linked to events which are unknown at issue (for example, reverse floaters and linked bonds), or those with coupons initially determined, but not constant over time (for example, step down and step up bonds).

Other bonds are far from the traditional concept of bonds, because they do not guarantee the full return of the principal. This is an extremely crucial characteristic for investors to keep in mind, as it radically changes the risk profile of the investment and investors in the past have often not been aware of this.

Reverse convertibles are this type of bond. Due to their wide circulation and the fact that their characteristics are often incorrectly assessed, we will take an in-depth look at reverse convertible. Subsequently, we will also provide an overview of other structured bonds which are gaining importance on the Italian market.

Reverse convertibles are financial instruments which offer investors a high coupon. However, they involve the risk that, upon maturity, in place of the capital initially invested, the investor may receive the number of shares whose value is less than the original investment.

Banks use these instruments to support collection of savings. These products can also fulfil another purpose, that of covering risks assumed through other methods.

A reverse convertible is a structured financial product because, as we have seen, it contains two components: a bond component (nominal value plus coupon) and a derivative component (put option). To fully understand what you are buying it is useful to unbundle the security into its components.

In our example, the subscriber purchases the right to a 15% coupon, and grants the issuer the right to sell the subscriber 200 Gamma shares, at the price of € 10 each, for a total value of € 2,000 (which is the amount that the subscriber pays to purchase the reverse convertible). Once the two components have been identified, they can be assigned a value: this is the first step in assessing the cost-effectiveness of the investment.

The value of the bond component can be objectively determined, by discounting the expected cash flow at money market rates. In our example, assuming a market rate of 5%, we need to determine the discounted value of a financial asset which will take on a value of € 2,300 after one year. The formula is as follows:

Va =C_t/(1+i)t where:

- Va is the discounted value that you want to determine;
- C_t is the expected yield at the end of the period (in our example, € 2,300);
- i is the yearly money market rate (in our example: 5%);
- t is the period of reference (in our case, one year = 1).

The discounted value that results from this formula is € 2,190.40.

However, the fact that the investor paid only € 2,000 does not imply that this is a particularly advantageous investment. The different of € 190.4 represents the price that the issuer pays to the investor to acquire the put option. Can the price of € 190.40 be considered fair?

To answer this question, you must calculate the theoretical value of the option. A calculator is provided on www.consob.it for this purpose. It is important to specify that, different to calculating the value of the bond component, calculating the value of an option involves identifying several factors (most importantly, volatility) whose value is estimated.

This issue is covered in depth in the guide to covered warrants, in the chapter "How is the value of a covered warrant calculated?". It is absolutely crucial to read the indications provided regarding covered warrants in order to assess the congruity of the price of the put option included in the reverse convertible, using the calculator provided on our website.

We were unable to set up the calculator to provide solely the correct value of the option, due to the objective difficulties in determining the value of the option, resulting from the need to "estimate", on a case by case basis, some factors required for the calculation. Instead, the calculator provides several prices of the option, each calculated with different predetermined levels of volatility (10%, 30%, 50%, 70%, and 90%).

For simplicity of use, the calculator does not require you to input the datum regarding the dividend on the share underlying the put option, as this cannot be easily estimated. As a result, the option prices provided by the calculator will be underestimated, in the presence of a positive estimate of the expected dividend.

As regards the above, if the price that the issuer pays for the put option is less than all prices provided by the calculator, this price is almost certainly incongruent, and the investor receives less than the amount owed.

If, on the contrary, the price offered by the issuer is near one of those provided by the calculator, you must compare the level of volatility assumed by the calculator to determine that price, and the typical volatility of the share, or, at least, the typical volatility of the sector. If the volatility considered by the calculator to determine the approximate price to that offered by the issuer is significantly lower than the volatility of the security or the sector, it is likely, also in this case, that the price paid by the issuer is less than the real value of the option.

Data on the volatility of the security or its sector may be found in the press or on specialised internet sites. For securities listed on the Italian electronic share market (MTA), this data is supplied by the calculator on Consob's site. Specifically, the historical volatility data (at 1, 3, 6, 9 and 12 months), used to calculated the corresponding prices of the put options is shown. Thus, it is possible to investigate the congruity of the price paid by the issuer by comparing it with the price determined by the calculator based on the historical volatility for the period comparable with the maturity of the reverse convertible. However, you must consider that as historical volatility refers to the past, it is not necessarily indicative of the future trend in volatility of the security.

For shares listed on the MTA which, at the same time, underlie the options exchanged on the IDEM market, in order to make the comparison more meaningful, the calculator also provides the figure, determined according to the criteria set forth by the Cassa di Compensazione e Garanzia spa, of implicit volatility linked to the put option, included in the reverse convertible. Implicit volatility is assigned its name because it is deduced from the prices of the options contracts effectively traded no the markets. Thus, it represents the market orientation regarding the expected volatility of an asset. As such, it constitutes a further parameter which may be used to investigate the congruity of the price paid by the issuer.

As we have seen, the results provided by the calculator are affected by a certain degree of approximation which, in any event, is inevitable in order not to make the tool too complicated to be used. For this reason, the data provided must be "interpreted" and may lead to the identification, with reasonable certainty, of only the cases in which the price that the subscriber receives from the issuer is clearly unfair. In other cases, it may provide indications which must be assessed on a case by case basis.

It is clear that the calculator will work only in the case where the investor is aware of all the data required. In some cases, as we will illustrate (the second rule contained in the chapter "Three rules for investing in reverse convertibles"), the issuer sets the strike price (and thus, the nominal value) only on the day of issue, and thus, the day following that in which the subscriber undertakes the commitment. In these cases, the investor may purchase without knowing important elements of the contract which are necessary in order to use the calculator (the calculator is on www.consob.it).

Currently, reverse convertibles are not listed on the electronic bond and government bond market (MOT). The regulations of Borsa Italian spa, in fact, include a specific provision which prohibits admission to this market of securities which may be repaid at a value lower than their nominal value.

Even if they are not admitted to Italian regulated markets, reverse convertibles may be traded on alternative trading systems (ATS) pursuant to Article 78 of the Consolidated Law on Finance, or through the issuer itself. However, these types of trading are not necessarily comparable in terms of transparency of price formation and liquidity, to trading on an official market.

This means that investors intending to resell their securities will most likely have the same issuer as a counterparty, and must execute the transaction at the price set by the issuer.

1. Know the product

Read the information prospectus and/or the detailed fact sheet and the issue regulations in order to fully understand the characteristics of the product and, specifically, the level of risk exposure involved in the product (subscribing to a reverse convertible is not the same as subscribing to a government bond!).

In addition, it is important to ensure that the characteristics of the product correspond to your needs, to your equity situation, your propensity towards risk, and your experience in the investment field (the characteristics of an investor who usually subscribes to government bonds are different from those of investors who operate in derivatives).

Then, make sure you understand, also by obtaining help from the intermediary proposing the investment, the tax regime which applies to the reverse convertible.

2. The potential information advantage for investors

In general, there are several precautions that may be taken to reduce the likelihood that an investment in reverse convertibles may lead to a loss of principal.

It must be noted that some of the suggestions provided in this section refer to the most common case of reverse convertible issuers, where the option that the investor sells to the issuer is at-the-money at the moment of creation of the reverse convertible.

In order to fully understand the significance of a reverse convertible in which the option sold is at-the-money, we will again look at the example set forth above.

Security: Reverse convertible on Gamma shares
Minimum size of the security (or nominal value): € 2000
Coupon interest rate, net of withholding of 27%: 15%
No. of underlying Gamma shares: 200
Strike price: € 10
Launch date: 1 July 2000
Maturity: 1 year

The put option implicit in the structure is at-the-money at the moment the reverse convertible is created if the price of the Gamma share on that day is approximately equal to the strike price of the put option (and thus, to the reference value of the shares). This means that the coupon that the investor will receive upon maturity only takes into account the value of the premium of an at-the-money put option. If we take another look at the example in the unbundling section, assuming, that is, that the market interest rate is equal to 5%, the remaining 10% of the coupon can be considered, in a very wide interpretation, as the premium of the put option that the investor has sold. This premium was calculated on an at-the-money option.

At times, several days (or even weeks) pass from the moment the reverse convertible is created to the moment the investor can subscribe to it. This is due to the time required to prepare the fact sheets and/or prospectuses, to set up all the commercial operations, etc.

During this period, stock market conditions change and may change very quickly for these products. In fact, by the time the investor subscribes to the reverse convertible, it is highly likely that all the variables which influence the value of this security will have changed (price of the underlying share, volatility, expected dividend, etc.), but the contractual conditions of the reverse convertible will not have changed.

In summary: the reverse convertible is created and all contractual conditions (subscription price, coupon, strike price, etc.) are set on a certain date. Therefore, it is more convenient for the investor to purchase on the last day available for subscription, in order to make use of all the information on the underlying security.

Recently, reverse convertible issues have increasingly set the strike price on the issue date (1 July in the example, thus eliminating the possibility of assessments regarding the performance of the underlying share. Nonetheless, the comments regarding volatility remain valid: A sharp increase in volatility decreases the value of the reverse convertible and makes delivery of the shares more likely.

3. Further precautions

The creation and subsequent distribution of a reverse convertible involves many parties in addition to the issuer, the placement banks and the investors-purchasers.

Often, the option that an investor sells to an issuer is, in turn, sold by the issuer to other intermediaries. These intermediaries may decide to keep it in portfolio, together with thousands of other positions, or to sell it again. The result of these processes is that, often, the final intermediary who holds the option in portfolio has nothing to do with the issuer, or with the reverse convertible, but finds himself required to manage this position in such a way as to make it profitable.

For various reasons, many of theM independent of the will of single intermediaries, and due to several technical reasons linked to risk management, as is the case for all derivatives, the price of the underlying upon maturity may be affected by pressure in a direction that is unfavourable to the investor, when the underlying is near the strike price.

For this reason, it may be useful to take several precautions when considering purchasing a reverse convertible.

A) Check the liquidity of the underlying

The more liquid a security is, the more unlikely it is that these "pressures" will arise or will have an effect.

It is preferable not to purchase reverse convertibles with underlying shares with low levels of liquidity (it is better, then, to choose MIB30 securities, or very well-known, traditionally liquid securities).

B) Check the amount issued

It should be made clear that the greater the amount of the loan, the greater the value of the position in derivatives (and the greater the value of the put option implicit in the structure). For this reason, it is likely that the "pressures" will be accentuated as the value of the issue increases. This leads to the consideration that it may be preferable to favour issues of smaller amounts compared to large issues.

C) Check the maturity date (or "Triple Witching Day")

What price is used to define the redemption price of the reverse convertible? The official price – reference price, opening price, closing price, etc. These are the prices generally used to determine the settlement method for derivative financial products, including reverse convertibles. It is preferable to choose reverse convertibles with the official price, or, at least the reference price, designated as the price to be compared with the strike price at maturity.

It is unadvisable to purchase reverse convertibles with the closing price, or even the opening price designated as the price to be compared with the strike price at maturity. In fact, in the opening phase, liquidity is low, and institutional operators are not required, different to that set forth for derivative products listed on the IDEM, to present in advance purchase and sell orders deriving from their own risk management procedures. This could mean that the market might not be able to adjust quickly enough to those orders, and thus, prices could undergo pressure in a direction unfavourable to the investor.

Again, it is preferable not to buy reverse convertibles expiring on specific trading days, which are characterised by levels of trading on underlying securities (for example, near 6 January, 1 November, 8 December, etc.).

D) Obtain details on the knock-in clause

The presence of "pressure" may be even more significant in the case of reverse convertibles with a knock-in clause. In this case, it is normally set forth that any price equal to or less than the knock-in, recorded at any moment of stock market trading during the entire life of the security, may be considered valid for determining breach of the barrier level. Remember that this barrier level is lower than the strike price. Thus, the breach of the barrier will mean that the option is already in-the-money, and thus, this increases the likelihood that the investor will receive the securities or cash settlement in place of the nominal value subscribed.

Only reverse convertibles issued by parties other than banks or, if issued by banks, only those which include the physical delivery of the shares are subject to supervision by Consob within the regulations governing public offering .

Public offering of a financial instrument is generally subject to these regulations. Our regime, however, does not require this supervision for offerings by banks, involving financial products different to shares or financial instruments that allow investors to purchase or subscribe shares.

We have seen that reverse convertibles with cash settlement do not enable investors to directly purchase shares, but, if the requisites are met, provide the delivery to the investor of an amount of money equal to the value of said shares. Therefore, the public offering of these securities is excluded from the regulations on public offering.

These regulations are applied to reverse convertibles which, on the contrary, involve the physical delivery of the shares to the subscriber (Consob Communication no. DIS/98066302 of 13 August 1998).

Thus, public offering of reverse convertibles with physical delivery must be preceded by the publication of an information prospectus.

Consob carries out investigations on the transparency of the operation, and the compliance of the methods by which public offerings are made. A financial operation is transparent when investors are able to assess its characteristics, cost-effectiveness and risks as a result of information disclosed. The main information instrument for the public is the information prospectus, the contents of which is preventatively submitted to Consob.

In addition to transparency, Consob also supervises in order to ensure that the operation is carried out according to principles of proper conduct, which the issuer and the placement agents must comply with. All in the interest of investors.

Lastly, for each issue, banks are required to provide a detailed fact sheet to investors, pursuant to the provisions of the Bank of Italy.

For those interested in more information on the topics covered herein, Consob has published several Quaderni di Finanza on these matters. Specifically, we recommend reading the following:

No. 25 - Volatilità dei titoli industriali e volatilità dei titoli finanziari: alcuni fatti stilizzati (M. Bagella and L.Becchetti);

No. 35 - La quotazione e l'offerta al pubblico di obbligazioni strutturate (M. Longo, G. Siciliano);

No. 39 - Il mercato primario delle obbligazioni bancarie strutturate (G. D'Agostino, M. Minenna);

No. 48 - Reverse Convertible: costruzione e analisi degli effetti sul mercato dei titoli sottostanti (D. Canestri, L. Amadei).