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Equity Linked Note Structures PART 3

Author: Financial-edu.com


Principal-at-Risk Equity Linked Notes

Example 2:  Annual Review Equity Linked Note

An Equity-Linked Annual Review Note has a coupon which is paid only if the underlying equity price closes above its starting price on specified yearly sample dates.  For example, a 3 year note may have a coupon of 8.5% per year, contingent on the Dow Jones Industrial Average (DJIA, INDU) closing above its price as of the start date of the note (assume 12,200 for this example), with measurements taken at the end of year 1, year 2, and year 3.  For each year that the DJIA closes above 12,200 (Zone 1 below) the investor accrues one year of interest at 8.5% per annum.  For each year the DJIA closes below this level (Zone 2 below), the investor accrues no interest. At maturity, the Annual Review Note pays the sum of accrued interest and principal to the investor. 

Annual Review Notes are usually structured with a lower principal protection barrier, for example -12%.  If the DJIA closes more than 12% below its starting value of 12,200 (Zone 3 below), the investor's principal is no longer guaranteed, and begins to float with the DJIA price.  If the DJIA stays above this lower barrier, the investor's principal is 100% guaranteed. 



For the investor, an Annual Review Note offers a relatively high contingent coupon, investment-grade rating (because it is based on the bank's credit rating, not the underlying equity's), and some principal protection (although not 100%).  The investor will profit most if the underlying equity price closes above the starting price on each annual sample date.  The risk to the investor is if the underlying equity price closes below the lower principal protection barrier and stays there on all annual sample dates.  In this case, no coupon is paid, and the investor receives back principal equal to 100% minus the equity percentage loss (e.g. 100% - loss of 25% = 75% of original principal).

For the bank, an Annual Review Note offers the ability to profit when the underlying equity closes below the starting price on the majority of annual review dates.  When the equity price is below the starting price, the bank pays no interest to the investor for the entire year previous to the sample date - essentially free capital.  The risk to the bank is if the equity price rises above the starting price and stays there on all annual review dates.  In this case, the bank must pay 100% of the principal back, plus 8.5% for each of the 3 years (potentially compounded depending on the note's terms).  If the equity price drops below the lower principal protection barrier, the bank has little or no risk, since only the remaining portion of principal adjusted by equity percentage loss must be returned to the investor at maturity.  Like the other structured notes presented here, banks typically hedge their exposure with a combination of equity put and call options, and attempt to earn a spread between the note and the options.

Example 3:  Accrued Coupon Equity Linked Note

An Accrued Coupon Equity Linked Note has a potentially high coupon paid on a regular quarterly or semi-annual basis, with the coupon's accrual dependent on the price of one or more underlying reference equities.  If the equity price does not drop more than a certain amount (say 15%) from the start date of the note, then the high coupon accrues daily.  If the equity price drops more than 15% from the note starting price, the coupon stops accruing, but resumes accruing if the equity price rises once again above the -15% barrier.

An example Accrued Coupon Equity Linked Note might be linked to two equities, such as British Petroleum and Chevron Texaco, with a maturity of 18 months, and a potential coupon up to 15%, payable on a quarterly basis.  As long as neither stock declines by 15% or more, the 15% coupon accrues on a daily basis.  If EITHER stock declines by 15% or more, then the coupon stops accruing until the point (if ever) both reference stock prices once again close above 85% of their initial starting prices. 



An Accrued Coupon Equity Linked Note may or may not have principal protection above the lower return barrier, and no principal protection below this barrier.  If principal is protected above the -15% lower return barrier, the investor receives 100% of the initial principal back if one or both of the equity prices drop below 0% but remain above the -15% barrier.  If one equity drops below the -15% barrier, then the amount of principal returned is the average of both equities' percentage return times the original principal amount of the note. 

Here are some example calculations for principal protection above the lower return barrier (worth about 2% extra to the investor here):

Equity A return = +10%
Equity B return = -12% (ABOVE -15% BARRIER)
Average of A and B = (10% - 12%) / 2 = -2%
Principal paid to investor at maturity = $100 x 1.0 = $100

Equity A return = +10%
Equity B return = -20% (BELOW -15% BARRIER)
Average of A and B = (10% - 20%) / 2 = -5%
Principal paid to investor at maturity = $100 x 0.95 = $95


Compare to no principal protection above the lower return barrier:

Equity A return = +10%
Equity B return = -12%
Average of A and B = (10% - 12%) / 2 = -2%
Principal paid to investor at maturity = $100 x 0.98= $98

Equity A return = +10%
Equity B return = -20% (BELOW -15% BARRIER)
Average of A and B = (10% - 20%) / 2 = -5%
Principal paid to investor at maturity = $100 x 0.95 = $95


<< BACK TO PART 2     CONTINUED IN PART 4 >>

 
 
 


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