Equity Linked Notes (ELN) are issued by major financial institutions such as Deutsche Bank, BNP Paribas and KBC Bank. The notes carry a legal liability against these issuing institutions.
Most ELNs have a maturity range from 1 to 2 months. The notes are structured by a zero coupon bond combined with a short position of a put option. In other words an investment that anticipates a price rise of the underlying stock.
Investing in ELN is the same as selling a put option on an underlying stock and at the same time placing a deposit with the ELN issuer. High gains from this structured product can be obtained from the option premium received on the short put option plus the accrued interest income derived from placing a deposit with the issuer.
Investors determine their risk/reward preferences by making a number of choices:
i. Selecting the underlying stock
ii. Selecting the maturity date
iii. Choosing the strike (exercise) price of the put option
iv. Choosing the date (hence the spot price) when the ELN is transacted
Since the strike price is often fixed below the spot (market) price of the underlying stock, there is an opportunity to acquire the underlying stock at a lower price if the embedded put option is exercised.
ELNs are issued at a discount to par. This is calculated by discounting the ELN's face value at the market interest rate from the time of maturity minus the premium received for the embedded short put option. For Hong Kong underlying stocks the payoff is generally fixed two business days before the ELN matures (fixing date is always the same as the expiry date of the embedded put option).
ELN has two payoff possibilities. The investor receives the full face value of the ELN on the fixing date if the underlying stock price closes at or above the strike (exercise) price of the embedded option. Conversely if the underlying stock price closes below the strike (exercise) price of the embedded option, the investor will be obliged to take delivery of the underlying stock at the strike price. The number of shares to be received on maturity is calculated by dividing the ELN's full face value by the strike (exercise) price of the embedded put option.
In essence a Bull ELN is most suitable for investors with a short to medium term, mild bullish view on a stock. It offers the chance to buy the stock at a strike (exercise) price which is normally below the current market spot price. Alternatively if the underlying stock closes at or above the strike (exercise) price, the investor will enjoy returns from a higher than market interest rate.
Payoff diagram at maturity
Pricing factors of ELN
- Dividend
- Interest rate
- Liquidity of underlying stock
- Maturity
- Strike/spot ratio
- Volatility of underlying stock
Risks
•
The price of underlying asset may continue to decline after the investor takes delivery of the underlying stock
•
Changes in ELN's pricing factors lead to uncertainty over its value, and thus the investor's return may be affected when selling back to the issuer before maturity
•
The investor is taking on the credit risk of issuer
Example
Trade Date
Today
Issuer
Investment Bank
Notional Amount
HK$ 1,000,000.00
Underlying Stock
Cheung Kong Holdings (CKH) 0001.HK
Price
97.29%
Transaction Amount
HK$ 972,900.00
Payment
T+ 14 (calendar day)
Maturity
T+ 45 (31- day life)
Strike (Exercise) Price
67.00
Spot Price
70.00 (as at time of execution)
Fixing Date
T+ 43 (2 days before maturity)
Currency
HK Dollar
Clearing Agents
Euroclear and Clearstream
Final Settlement
Cash settlement or physical delivery of shares through CCASS
Share Entitlement
14,925 CKH shares
ELN Annualized Yield
32.80% p.a.
Related Formula
M =
Maturity Date
P =
Payment Date
r =
Deposit Interest Rate (assume HKD 365 days)
Strike =
Strike Price
=
Put Premium from Contract Date to Fixing Date.
Theoreatical Put$ can be calculated by using Black-Scholes Model.
This website is intended to be accessed by sophisticated and professional investors in Hong Kong only.
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