An Insight into Banks' Pricing: The Case of Covered Warrant

At the end of 1990s, the issuance of option contracts was mostly a privilege of the official option exchange, but around the years 1998-1999 banks started to issue a large number of option-like securities named warrant or, as in Italy, covered warrant. These instruments are expected to have the same price of traditional options when they carry the same payoff structure. This paper compares the Italian covered warrant market with the traditional option market. We perform such a comparison by matching covered warrants written on Italian stocks with comparable options on the IDEM (Italian Derivatives Market), that is to say, options having the same underlying, strike price and maturity. Otherwise, when the match is not possible with options available on this market, we generate market-consistent prices of comparable options by means of pricing models. The results confirm the presence of a systematic overpricing of the warrants with respect to the options; in line with the evidences from other European covered warrant market. In particular, we find that the overpricing is relevant with respect to the option, but also among the different issuers. It seems clear that the theoretical argument does not hold because the differences between the two instruments, in terms of financial products, are not marginal as supposed and that the specific nature of the issuers, banks, influences the overpricing. The results of the regression analysis performed to test the relationship between the overpricing and market variables offer only weak evidences. As possible explanation, we emphasize that the participation costs, as defined by Allen and Santomero (1997, 2001), play a crucial role in explaining why the investors are willing to pay a higher price for the covered warrants. Another possible explanation is that the lower number of issuers implies a higher market power and allows banks for setting higher prices.