Equity Linked Notes or ELNs for short are marketed to Accredited Investors. Here is an example:
The ELN is linked with the performance of 15 companies. The ELN earns a fix 4% yield for each year provided the 15 companies’ shares are above certain predetermined share prices known as the strike prices. Typically the strike prices are 20% to 30% below the current prices of these companies. Assume the probability of each company share price above the strike price is 90% (I deliberately give it an optimistic figure as this is reasonable during a bull run). Than the probability of the ELN earning 4% for that year is 0.9015 = 20%! Therefore, even if the market is in a bull run, the chances of the product yielding a mere 4% has been reduced from 90% to just 20%. What is the expected yield? Expected yield is 4%*20% + 0%*80%=0.8% per annum. It will be better off that the investor just buy the 15 companies directly. Mathematically, P(A and B and C….) = P(A)P(B)P(C)….
I have an actual real client who bought an ELN from the bank thinking it was a safe product. Unfortunately, one of the underlying company’s share price went below the strike price. As a result, his entire ELN worth $500,000 was converted to the shares of the worst performing stock. The conversion was based on the stock price NOT at the time of conversion but at the price when the ELN was first purchased. He made a whopping immediate 50% loss.
The ELN is a terrible lemon. It consists of two embedded products:
- A bond “guaranteed” by a third party. Thus, there is a credit risk.
- A put option (from the point of view of the issuer) and a short put option (from the point of view of the investor).
Effectively the investor becomes the insurance company protecting the issuer (usually the bank) if the stock prices crashed.
Equity Linked Note is an instrument that is used to tap on the financial resources of the high networth to protect the bank for major losses. The joke is that the investor does not even know they are made used off. When an investor buys an Equity Linked Note and suffer major losses, it is like being getting into a traffic accident without any chance of recovery.
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