An Equity-Linked Note (ELN) is an instrument that provides investors fixed income like principal protection together with equity market upside exposure.
An ELN is structured by combining the economics of a long call option on equity with a long discount bond position.
The investment structure generally provides 100% principal protection. The coupon or final payment at maturity is determined by the appreciation of the underlying equity.
The instrument is appropriate for conservative equity investors or fixed income investors who desire equity exposure with controlled risk.
An Equity-Linked Note (ELN) is a debt instrument that differs from a standard fixed-income security in that the coupon is based on the return of a single stock, basket of stocks or equity index (the “underlying equity”). An ELN is a principal-protected instrument generally designed to return 100% of the original investment at maturity, but diverges from a standard fixed-coupon bond in that its coupon is determined by the appreciation of the underlying equity.
There are many groups of investors who incorporate ELN’s into their investment strategies, including:
Conservative, risk averse equity investors or intermediate-term fixed-income investors.
Tax-exempt/tax-deferred accounts and off-shore accounts.
Investors for whom structural problems prohibit or limit equity allocations (e.g., certain trusts, retirement accounts/pension funds or insurance companies).
The Equity-Linked Note can be constructed by packaging a call option and a zero coupon bond. The call option provides the note buyer with exposure to the underlying equity. The zero coupon bond provides the note buyer with principal protection. A zero coupon bond allows for principal protection since it accretes from its discount value to its par value over a specified period of time without periodic payments of interest. The discount from the par value of the zero coupon bond can be used to purchase the call option on the underlying equity.
Bond + Call Option => Equity Linked Note => Principal Protection + Equity Participation
The payoff of a typical equity-linked note is equal to the par amount of the note plus an equity-linked coupon. In general, the equity-linked coupon is equal to either:
(a) zero, if the underlying equity has depreciated from an agreed upon strike level (usually the index level on the issue date of the note), or
(b) the participation rate times the percentage change in the underlying equity times the par amount of the note, if the underlying appreciated.
The participation rate is the rate at which the ELN investor participates in the appreciation of the underlying equity. For example, a participation rate of 100% implies that a 10% increase in the underlying equity will result in a final equity-linked coupon of 10%. If the participation rate were instead 75%, a 10% increase in the underlying equity would mean a final equity-linked coupon of 7.5%. The participation rate is typically adjusted so that the ELN may sell at par.
As an example of an ELN, assume an investor buys a hypothetical five-year 100% principal protected Equity-Linked Note with 100% participation in the upside of the S&P Nifty Index for Rs. 1,000. The starting index level is 1,400.
At maturity, if the S&P Nifty Index level is above 1,400, then the payoff of the note will be Rs. 1,000 in principal plus an equity-linked coupon equivalent to any increase in the index.
For example, if the index level in five years is 2,100 (an appreciation of 50%), then the coupon would be Rs. 500 (100%*50%*1,000) and the total payoff would be Rs. 1,500 (1,000 + 500).
If the index level is below 1,400 at maturity, i.e., the underlying equity performance is negative, the final payoff to the investor will be Rs. 1,000 in principal.
Upside potential. The upside potential for this hypothetical ELN is unlimited. The potential positive return on the notes is the same as the positive price return on the S&P Nifty Index.
Downside risk. The downside risk is limited. The equity-linked note provides full principal protection. Regardless of the final S&P Nifty Index level, principal is returned.
Opportunity Cost. Although ELN’s repay an investor their principal at maturity, there is an opportunity cost even where an investor receives a return of principal in down markets; i.e., that investor has lost the use of his/her invested principal for the term of the ELN (in an investment in a risk-free asset like a T-bill, for example).
Opportunity cost can be defined as the forgone “risk-free rate of return” that could have been achieved had the principal been invested in safe fixed-income securities, such as T-bills, for the same period. For example, an investment of Rs. 1,000 on a 6% per annum coupon bond will return Rs. 1,338 at maturity, Rs. 338 higher than the ELN. The equity-linked note will outperform the bond as long as the S&P Nifty Index reaches a level higher than Rs. 1,875 at maturity.
Synthetic Equivalent. To synthetically create an ELN, an investor would (1) invest in a five-year 6% discount bond for Rs. 747.26 (1,000/(1.06)^5) and (2) buy a five-year, S&P Nifty at-the-money call option on Rs. 1,000 notional amount with a Rs. 1,400 strike for Rs. 252.74. The initial investment for this structure is Rs. 1,000, the same as for the ELN (Rs. 747.26+ Rs. 252.74).
If the S&P Nifty Index level in five years is above 1,400, then the call option expires in-the-money. For example, if the S&P level is 2,100, then the payoff of the option is Rs. 500 (50% appreciation of the index multiplied by Rs. 1,000 notional amount). The payoff of the option, combined with the Rs. 1,000 principal from the bond equals the Rs. 1,500 payoff of the ELN.
If the S&P Nifty Index level is below 1,400, then the call option expires out-of-the money, or worthless. The total payoff is therefore Rs. 1,000 from the discount bond, same as the ELN.
Equity-Linked notes are flexible securities that can be structured to match the investor’s risk-reward objectives. For example, the equity-linked coupon can be based on a variety of domestic and international market indices and individual stocks. By adjusting the amount of principal protection or capping the upside potential, there may be opportunity for increased participation and/or higher potential returns. The note can be designed to have coupons payable on a monthly, quarterly or semiannual basis. For international indices, the equity component can be priced with and without currency exposure. Finally, the note can be structured so as to achieve a desired participation rate.
Factors affecting Price of an ELN
The Business Telegraph (Kolkata, India - 1-Sep-2008)
An ELN is structured by combining the economics of a long call option on equity with a long discount bond position.
The investment structure generally provides 100% principal protection. The coupon or final payment at maturity is determined by the appreciation of the underlying equity.
The instrument is appropriate for conservative equity investors or fixed income investors who desire equity exposure with controlled risk.
An Equity-Linked Note (ELN) is a debt instrument that differs from a standard fixed-income security in that the coupon is based on the return of a single stock, basket of stocks or equity index (the “underlying equity”). An ELN is a principal-protected instrument generally designed to return 100% of the original investment at maturity, but diverges from a standard fixed-coupon bond in that its coupon is determined by the appreciation of the underlying equity.
There are many groups of investors who incorporate ELN’s into their investment strategies, including:
Conservative, risk averse equity investors or intermediate-term fixed-income investors.
Tax-exempt/tax-deferred accounts and off-shore accounts.
Investors for whom structural problems prohibit or limit equity allocations (e.g., certain trusts, retirement accounts/pension funds or insurance companies).
The Equity-Linked Note can be constructed by packaging a call option and a zero coupon bond. The call option provides the note buyer with exposure to the underlying equity. The zero coupon bond provides the note buyer with principal protection. A zero coupon bond allows for principal protection since it accretes from its discount value to its par value over a specified period of time without periodic payments of interest. The discount from the par value of the zero coupon bond can be used to purchase the call option on the underlying equity.
Bond + Call Option => Equity Linked Note => Principal Protection + Equity Participation
The payoff of a typical equity-linked note is equal to the par amount of the note plus an equity-linked coupon. In general, the equity-linked coupon is equal to either:
(a) zero, if the underlying equity has depreciated from an agreed upon strike level (usually the index level on the issue date of the note), or
(b) the participation rate times the percentage change in the underlying equity times the par amount of the note, if the underlying appreciated.
The participation rate is the rate at which the ELN investor participates in the appreciation of the underlying equity. For example, a participation rate of 100% implies that a 10% increase in the underlying equity will result in a final equity-linked coupon of 10%. If the participation rate were instead 75%, a 10% increase in the underlying equity would mean a final equity-linked coupon of 7.5%. The participation rate is typically adjusted so that the ELN may sell at par.
As an example of an ELN, assume an investor buys a hypothetical five-year 100% principal protected Equity-Linked Note with 100% participation in the upside of the S&P Nifty Index for Rs. 1,000. The starting index level is 1,400.
At maturity, if the S&P Nifty Index level is above 1,400, then the payoff of the note will be Rs. 1,000 in principal plus an equity-linked coupon equivalent to any increase in the index.
For example, if the index level in five years is 2,100 (an appreciation of 50%), then the coupon would be Rs. 500 (100%*50%*1,000) and the total payoff would be Rs. 1,500 (1,000 + 500).
If the index level is below 1,400 at maturity, i.e., the underlying equity performance is negative, the final payoff to the investor will be Rs. 1,000 in principal.
Upside potential. The upside potential for this hypothetical ELN is unlimited. The potential positive return on the notes is the same as the positive price return on the S&P Nifty Index.
Downside risk. The downside risk is limited. The equity-linked note provides full principal protection. Regardless of the final S&P Nifty Index level, principal is returned.
Opportunity Cost. Although ELN’s repay an investor their principal at maturity, there is an opportunity cost even where an investor receives a return of principal in down markets; i.e., that investor has lost the use of his/her invested principal for the term of the ELN (in an investment in a risk-free asset like a T-bill, for example).
Opportunity cost can be defined as the forgone “risk-free rate of return” that could have been achieved had the principal been invested in safe fixed-income securities, such as T-bills, for the same period. For example, an investment of Rs. 1,000 on a 6% per annum coupon bond will return Rs. 1,338 at maturity, Rs. 338 higher than the ELN. The equity-linked note will outperform the bond as long as the S&P Nifty Index reaches a level higher than Rs. 1,875 at maturity.
Synthetic Equivalent. To synthetically create an ELN, an investor would (1) invest in a five-year 6% discount bond for Rs. 747.26 (1,000/(1.06)^5) and (2) buy a five-year, S&P Nifty at-the-money call option on Rs. 1,000 notional amount with a Rs. 1,400 strike for Rs. 252.74. The initial investment for this structure is Rs. 1,000, the same as for the ELN (Rs. 747.26+ Rs. 252.74).
If the S&P Nifty Index level in five years is above 1,400, then the call option expires in-the-money. For example, if the S&P level is 2,100, then the payoff of the option is Rs. 500 (50% appreciation of the index multiplied by Rs. 1,000 notional amount). The payoff of the option, combined with the Rs. 1,000 principal from the bond equals the Rs. 1,500 payoff of the ELN.
If the S&P Nifty Index level is below 1,400, then the call option expires out-of-the money, or worthless. The total payoff is therefore Rs. 1,000 from the discount bond, same as the ELN.
Equity-Linked notes are flexible securities that can be structured to match the investor’s risk-reward objectives. For example, the equity-linked coupon can be based on a variety of domestic and international market indices and individual stocks. By adjusting the amount of principal protection or capping the upside potential, there may be opportunity for increased participation and/or higher potential returns. The note can be designed to have coupons payable on a monthly, quarterly or semiannual basis. For international indices, the equity component can be priced with and without currency exposure. Finally, the note can be structured so as to achieve a desired participation rate.
Factors affecting Price of an ELN
- Increase in Equity Price (+)
- Increase in Volatility (+)
- Increase in Interest rates (+/-)
- Increase in Time to Expiration (+)
- Increase in Dividend Yield (-)
- Improved Credit Rating (+)
Let us take another example of an ELN (also called "Equity Linked Derivative", ELD)
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