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Equity Linked Note Structures PART 4


Principal-at-Risk Equity Linked Notes

Example 3: Accrued Coupon Equity Linked Note (continued)

An Accrued Coupon Equity Linked Note may be callable on the part of the bank (issuer).  If the note terms allow it, the bank will exercise its call option if one or either of the reference equity prices rise rapidly so the average price return of both equities exceeds the coupon rate.  Calling the note locks in the high coupon rate, which is then paid along with the full principal back to the investor within a few days of the call date.  Banks excercise the call feature to protect themselves, as these types of notes are generally hedged up to the coupon rate.  In our example, if both equity prices rise higher than 15% above their start value, the bank's hedge may lose money, so the deal is effectively canceled and the investor's accrued profits returned with minimal loss to the bank.

Key Features of Equity Linked Notes

Embedded Optionality

A major feature of Equity Linked Notes is their embedded optionality.  Issuing banks price these instruments based upon a combination of implied and historical probabilities that the underlying equity return will or will not move through one or more of the barriers before the expiration date of the note. 

Issuing banks (and presumably the sophisticated institutional investors who buy these notes) utilize complex statistical models to estimate the probabilities of each scenario occurring.  Real time models are used to price notes according to the estimated probability of future returns (typically with a price spread added for profit margin).

Unique or Custom Payment Structures

There is no limit to variations on an equity linked note's potential payment structure, when the payments occur, the conditions that trigger them, or their magnitude.  Many equity-linked deals for major corporate purchasers and pensions involve long term hedges against key risks such as the oil market, commodities, or Russian equity volatility.  Payments may be in the form of interest, discount from par (zero coupon, with the par amount paid at maturity contingent on an event), the percentage spread between two equities applied to the notional amount, or a combination of Asian lookback, Bermudan, or ratcheting strike options that raise or lower the interest rate or principal protection amount.

Non-Correlated Returns

While it is difficult to gather comparative market data due to the non-traded nature of equity linked notes, by simply analyzing several "what if?" scenarios, investors can make a reasonable estimate of the correlation/non-correlation of an ELN and the alternative bond or equity investment.  These deals tend to have fairly volatile valuations, which is largely caused by their embedded optionality.  Equity linked note prices are generally more correlated with equity market volatility than the actual direction of the markets themselves.

Pricing Equity Linked Notes

Pricing these complex structures is fairly difficult, and should be reserved for skilled quantitative analysts using real time statistical pricing models. 

The five components of pricing Equity Linked Notes are:

1) Equity price volatility:  The higher the implied and historical underling equity volatility, the higher the value of the embedded optionality.

2) Path dependency:  As markets change directions, one price path versus another may begin to take precedence in the form of a price trend.  The value of an equity linked note is highly dependent on the perceived (implied) probability of the price paths which will lead to higher or lower payouts.  These perceived path probabilities change on a constant basis.

3) Time to expiration:  The greater the time to expiration of the deal, the more "time value" it has in the embedded optionality component.  This may be offset by the increased risk of future cash flows on the interest rate component, which is affected greatly by the yield curve (corporate, treasury, LIBOR) and prevailing rates.

4) Location of the barriers or strikes:  The closer a knock-in barrier is to the current equity price, the greater value the equity linked note will have.  The closer a knock-out barrier is to the current price, the less value the equity linked not will have.  This is because the increased payout/reduced payout triggers are more likely to be hit if they are closer to the current reference price.  In the case of a European or Bermudan option, the time until an barrier can be exercised is also a factor -- the farther out, the greater time value.

5) Risk-free interest rate:  Since these instruments are notes, their cash flows are dependent on risk-free yield curves such as LIBOR or U.S. Treasury, or risky yield curves such as spread over Treasury curves.  These values are used to discount future cash flows, and the higher the discount rate, the less an equity linked note is generally worth, and vice-versa.



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