# Covered Warrants

#### What are the Covered Warrants?

Covered Warrants are financial instruments that give the right but not the obligation, to buy or sell a specific underlying asset at a predetermined price within a predetermined period ('American-style Covered Warrant) or within a predefined deadline (European-style Covered Warrant). They are derivative instruments as they derive their value from the price of the underlying financial asset. The underlying assets of Covered Warrants can be any traded activity on a regulated stock exchange, generally shares, market indexes, currencies, bonds and commodities. The optional right to buy or sell a certain underlying asset is represented by the price paid by the buyer to the seller. This amount of money is also known as a 'premium'.

Investment products that give the right, but not the obligation, to buy or sell an underlying asset at a predetermined price and date.

#### Standard elements of a Covered Warrant

Covered Warrants are securitized options and have the same standard elements of option contracts. The standard elements are:

- ISSUER: Whoever issues the instrument and guarantees its liquidity on the trading market or at maturity;
- UNDERLYING: Financial asset from which the Covered Warrant derives value.
- TYPE OF RIGHT: to be purchased when Covered Call Warrant is bought or to be sold when a Covered Put Warrant is bought
- STYLE: American or European
- STRIKE PRICE: the price of the financial activity at which it is possible to exercise the Covered Warrant right.
- MULTIPLIER: the number of underlying financial activities controlled by the Covered Warrant.
- EXPIRY: The period in which the American Style Covered Warrants can be exercised or the date at which the European Style Covered Warrants can be exercised.
- Minimum Lot: The minimum number of Covered Warrants that can be traded on the market.

Covered Warrants can be freely traded on the market or, in respect of American Covered Warrants exercised before their maturity. In the event of early exercise of the option before it expires, the owner loses the time value and collects only its intrinsic value. This economic element leads investors to favour the sale of Covered Warrants on the market rather its early exercise.

#### How they work

There are two types of Covered Warrants on the market: Call Warrants and Put Warrants. The former are financial instruments used by investors who have bullish expectations, expecting a rising market, with respect to the market value of the underlying asset, the latter are used by investors with bearish expectations, expecting the market to fall.

#### Operation to maturity of Covered Warrants

If the Covered Warrants were brought to an expiry date, they are automatically exercised and the investor is reimbursed by the issuer.

In the case of Covered Call Warrants the amount of money that the investor receives for each Covered Warrant held is equal to the difference, if positive, between the market price of the underlying asset and the exercise price multiplied by its multiplier.

#### Formula Covered Call Warrant

**COVERED WARRANT CALL VALUE = (UNDERLYING ASSET PRICE – EXERCISE PRICE OF CW) X MULTIPLIER**

#### Formula Covered Put Warrant

In the case of Put Warrants, the sum received by the investor for each Covered Warrant held is equal to the difference, if positive, between the exercise price and the market price of the underlying asset multiplied by the multiplier.

**COVERED WARRANT PUT VALUE = (EXERCISE PRICE OF CW-UNDERLYING ASSET PRICE) X MULTIPLIER**

A feature in the operation of a Covered Warrant is its responsiveness to price movements characterized by the leverage effect. Covered Warrants magnify, both upwards and downwards, the performance of the underlying in that the investment in Covered Warrants requires only a fraction of the capital that would be required for a direct investment in the underlying.

#### Characteristics

There are several variables that characterize the evolution of the market price of a Covered Warrant. Their value can be split into two main categories: intrinsic value and time value.

- INTRINSIC VALUE

The intrinsic value represents the revenue that would be received by exercising an American style warrant and it depends on the Stock market price of the underlying and on the exercise price or strike price. The intrinsic value of a Call Covered Warrant is calculated as the difference between the price of the underlying and the exercise price, all multiplied by the multiplier. The intrinsic value of a Put Covered Warrant is the difference between the strike price and the current price of the underlying, all multiplied by the multiplier.

- TIME VALUE

Time value represents the difference between the market value and the intrinsic value. Over a lifetime, a warrant is generally worth more than its simple intrinsic value. The importance of time value is crucial in the composition of the price of a Covered Warrant: the closer it gets to the expiry date of the instrument the more the time value decreases as the uncertainty related to the exercise or not of the Covered Warrants reduces. Consequently, the price of the instrument decreases bringing it closer to the intrinsic value.

#### Covered Warrant terminology

In practice, time value is nothing more than an expression of the probability that a warrant is 'In-the-money' at expiration. In the case of a Call Covered Warrant the term 'In the money' refers to a situation in which the current value of the underlying is greater than the current value of the underlying strike. When the current value of the underlying is exactly equal to that of the strike, the Covered Warrant is referred to as 'At the Money'. The term 'Out of the money' it indicates particular cases in which the market price of the underlying is lower than the strike price of the Call Covered Warrant or higher than the strike price of the Put Covered Warrant.

- OTHER FACTORS INFLUENCING THE PRICE OF A COVERED WARRANT

In addition to these two main categories, other elements can influence the price of a Covered Warrant. The factors that affect the value of these financial instruments are as follows:

#### Volatility

The volatility in the market value of the underlying is one of these factors, having a positive effect on the value of the Warrants as the more volatile a stock is, the greater the potential profit for the investor. There are two measures of volatility: historical volatility and implied volatility. Historical volatility is calculated on historical data of the underlying asset. Implied volatility is an estimate based on expectations of anticipated future price volatility of the underlying. As implied volatility is a prediction and is not made explicit by historical data.

#### Dividends and Interest rates

Expected dividends and interest rate levels for risk-free assets are other factors that influence the price of Covered Warrants. The higher the expected dividends of Call Warrants on the same underlying, decrease in value while the Put Warrants increase in value. As for interest rates, an increase will drive up the price of a Call Covered Warrant and decrease that of a Put Warrant (equal to other market factors).

The variables described are synthesised by some indices of sensitivity known as Greeks as they are represented by letters of the Greek alphabet. The Delta coefficient measures the sensitivity of the price of the Covered Warrants on the spot price of the underlying. The Vega influences the price of the volatile underlying component of the Covered Warrant. Rho is the price sensitivity of the Warrants to the interest rate. Gamma expresses the variation of Delta for a variation of a unit of the underlying value. Theta finally is the index which indicates the decline of the time value, namely, the way in which the value of the Covered Warrant changes with the diminishing residual maturity of the Covered Warrant.

#### Greeks and Covered Warrant values

The following table summarises the effect of an increase of the variables summarised by the Greeks on the theoretical value of a Call Covered Warrant and Put Warrants. The behaviour in case of a decline in the variables is speculative.

= increase in the value of the Covered Warrant

= decrease in the value of the Covered Warrant

#### Possible strategies (the most used / common)

Covered Warrants are financial products used by investors for multiple purposes. These tools can be used to implement various strategies. The most common are those related to the structuring of trading strategies, hedging and cash extraction.

#### Trading strategies

The most common strategy developed by the Covered Warrant is trading. These financial instruments make possible to achieve greater returns than a direct investment in the underlying. As a result of the leverage effect that characterises Covered Warrants, market prices for these products are more reactive and they magnify movements in price of the underlying financial asset. The leverage will also magnify any potential losses that may occur. The maximum loss is limited and equal to the capital invested, which is the premium paid to buy the Covered Warrant. The gains may instead be unlimited for those who buy a Call Covered Warrant. Put Covered Warrants have a ceiling on potential gains linked to the impossibility of the financial or real asset having a value less than zero.

#### Hedging strategy

Covered Warrants may also be used to protect investments from the risk of loss of value. This strategy is called hedging and represents a kind of insurance against losses in the value of individual stocks or entire equity portfolios held by the investor. Covered Warrants may also be used to cover financial investments held in a foreign currency that are subject to exchange rate risks rather than covering interest rate risks. The insurance, whose premium is the equivalent of the Covered Warrants purchased, is triggered in the event of a negative outcome covered by the investor. The hedging can be developed according to two different approaches:

- Static hedging i.e. this is the easiest method of coverage an investor can implement. Once the number of Covered Warrants has been identified to cover their position, the investor will never change the strategy. The drawback of this method is that the hedging will only be realised on the expiration date of the Covered Warrants.

**Number of Covered Warrants = Value of Portofolio in Euros **

**to be purchased Strike X Multiplier**

- Dynamic hedging is a more complex alternative to static hedging requiring periodic adjustments of the total number of covered warrants needed to cover the investor's position. It has the advantage of being a strategy that takes effect even before the expiry of the Covered Warrants. The dynamic hedging is linked to the introduction of the Delta coefficient in the definition of the number of Covered Warrants needed to cover the position. By measuring the sensitivity of the price of the Covered Warrants on the spot price of the underlying, the Delta coefficient varies continuously. It is this variation that leads to the need to rebalance the coverage with every significant deviation of Delta.

**Number of Covered = Value of the Portfolio in Euros **

**Warrants to be purchased Strike x Multiplier x Delta**

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#### Cash extraction strategy

A third strategy is called Cash Extraction. An investor who owns shares which have appreciated significantly in value may decide to cash in gains accrued by selling the shares on the market. He then subsequently invests only part of the capital proceeds from the sale of the initial investment in Covered Call Warrants on the same underlying. In this way any risks of a fall in value of the shares, maybe even substantial drops, will be eliminated while at the same time maintaining the ability to benefit from any further price revaluations of the same. In defining the terms of use, the investor will fix the maximum potential loss that he is willing to suffer, equal to the premium paid during the purchase of the Covered Warrants. Having defined the maximum acceptable loss, the investor will continue to benefit from the price movements of the financial asset underlying the Covered Warrants

#### Listing and Trading

Covered Warrants, both Call and Put Warrants, are financial instruments widely distributed in Italy since 1998 and can be bought and sold on the MTFs SeDeX and EuroTLX of the Italian Exchange. Methods and trading hours of such multilateral trading facilities are specified in the relevant Rule books, available on the website of the Italian Exchange. For example, on the SeDeX market, trading in the continuous phase may take place on the open market days between 9:05am and 5:30pm. Covered Warrants are negotiable from the time they are listed up to the third trading day of open Exchange prior to their maturity date. Covered Warrants may only be issued by intermediaries who are subject to prudential oversight and reflecting their duty to uphold sound equity and financial responsibilities.