Equity Linked Note Structures PART 1 Author: Financial-edu.com
An Equity Linked Note is a hybrid fixed income instrument whose return is partially dependent upon the performance of an underlying equity (stock, basket of stocks, index, basket of indexes, or some mix of these). These instruments are generally designed for the Over the Counter (OTC) institutional investment market. However, there are a growing number of exchange traded Equity Linked Notes available to retail investors. The market for Equity Linked Notes has grown at a rapid pace, driven by the need to generate returns tied to - but not directly correlated with - global equity markets.
There are two main categories of Equity Linked Notes: 1) those that offer guaranteed protection of the investor's principal, and 2) those that leave the investor's principal at risk.
Principal-Protected Equity Linked Notes
The first category of Equity Linked Notes offers guaranteed protection of the investor's principal. These are often linked to a broad equity index such as the Nikkei 225, S&P 500, DAX, Hang Seng or Russell 2000. Maturities range from 1 to 3 years. They are issued by large banks with the necessary assets to guarantee the investor's principal in the event of a significant equity market drop.
Example 1: Absolute Return Barrier Note (ARBN)
A popular principal-protected note is the Absolute Return Barrier Note (ARBN). An ARBN is useful where the investor believes the underlying equity market will move up or down moderately over the life of the note, but is unlikely to gain or drop a large amount.
An ARBN has an upper barrier and a lower barrier representing the top and bottom of a percentage return range or channel within which the underlying equity market is allowed to move. These barriers are thresholds or "strikes" quoted in percentages or price. If the underlying equity return crosses one of these barriers, it triggers a payment obligation on the part of the seller to return the investor's capital. If the underlying equity return does not cross the upper or lower barrier, then the investor receives the notional amount times the absolute equity return percentage at maturity.
In order for the investor to make a positive return on an ARBN it does not matter whether the equity price goes up or down, as long as it remains between the upper and lower barriers at all times. In other words, if the closing equity price stays within the upper and lower barriers:
Return percentage to investor = ABSOLUTE VALUE(percentage change of equity price since trade start date)
Return percentage to investor = 0%
For example, an Absolute Return Barrier Note linked to the S&P 500 could have its upper and lower barriers set at plus or minus 15%. If the S&P 500 stays within this +/- 15% range for the life of the note, the investor receives the absolute percentage return of the equity index at maturity. However, if the S&P 500 drops 17% or rises 20% from the note's start date at any time before expiration, the +/- 15% barrier would be triggered, and the investor would simply get his initial money back at maturity with no return or loss. When a return barrier is crossed, the investor's profit or loss "knocks out" and his initial capital is returned at maturity.
In the diagram below, only the note represented by the blue line stayed within the +/-15% return barriers for the life of the note, so it is the only one which would pay out a return above the principal. The other three notes crossed one of the barriers at some point in their lives, and only the investor's principal will be returned at maturity with 0% interest.
For the investor, an Absolute Return Barrier Note provides guaranteed principal protection, a hedge against a moderate drop in the underlying reference equity, plus the chance to earn a moderately positive return over the life of the note. The risk to the investor is opportunity cost: in the event the S&P 500 gains more than 15% before the expiration date then the investor loses all of the accrued positive return up to 15%. In addition, if either of the two 15% barriers is breached , the investor receives 100% of the principal back, but must wait until the note's maturity for the cash to be returned. Between the time when the return barrier is broken and the note maturity, the investor loses the interest rate that would have been earned elsewhere. (This is the opportunity cost of not investing in U.S. Treasuries or some other ultra-safe instrument in lieu of an equity linked note).
For the selling bank, the risk is that the underlying equity index never crosses one of the threshold barriers during the life of the note. In this case the bank must pay back the investor's principal, plus the accrued percentage return multiplied times the notional amount of the trade. The bank's hope is that the equity index will break one of the return barriers - the earlier the better. In this case, the bank must return the investor's capital at maturity, but will benefit from the ability to reinvest the entire principal amount for the whole life of the trade. The bank typically hedges the risk that the underlying equity price will remain between the barriers with put and call options. By doing this, the bank minimizes its potential loss and may even generate a small profit if the hedge can be purchased for less then the expected value of the potential loss.
CONTINUED IN PART 2 >>