Equity-Linked Note (ELN)
What is it: ELN is a type of structure note that links to the performance of the underlying assets (i.e. stock, ETF, index). There are different types of ELN such as Bull ELN, Worst-Of ELN, Knock-Out ELN, and Reverse ELN. While Bull ELN is the most common type. The following article is focused on the ‘Bull’ ELN.
When to buy: Neutral or bullish view & willing to take the stocks if price drops.
How ELNs work: ELNs are issued at a discount to par value. On the Final Valuation Date, investors receive 100% of the principal in cash if the underlying asset is at or above strike price; or receive physical shares if it is below the strike price.
Payoff at Maturity Date:
price above strike level = receive yield + initial investment
price below strike level = receive physical shares (Principal converted to Company A share at strike)
Example:
Issuer = ABC Bank
Currency = HKD
Underlying Asset: Stock A
Purchase Amount: 2,940,000
Nominal Amount: 3,000,000
Spot Price: $40
Issue Price: 98% of Spot Price
Strike Level: 95% of Spot Price
Tenor: 60 Days
Implied Yield: 12.41% p.a.
*Investor pay HKD 2,940,000 (nominal amount x issue price = 3,000,000 x 98%) to buy this ELN with notional of HKD 3,000,000.
All Scenarios (Price on Final Valuation Date)
Scenario 1
Price above strike level $38 (Spot Price x Strike Level = $40 x 95% = $38)
Investor receive HKD 3,000,000 (100% of notional amount)
Scenario 2
Price is exactly at strike level
Investor receive HKD 3,000,000 (100% of notional amount)
Scenario 3
Price below strike level
Investors receive physical shares of Stock A and paid at strike level
Investor will receive 78,947 shares (notional amount/strike = 3,000,000/$38 = 78,947)
Investor’s loss is equal to the difference between the final valuation date price & strike price
Scenario 4
Price drops to zero
Receive worthless shares
Maximum loss = the whole amount of investment
How to hedge: Issuers will do dynamic hedging when they sell ELN to investors. It involves buying underlying shares. When the prices go up, the likelihood of exercising the ELN drops, issuers will sell their hedges (i.e. sell underlying shares), and vice versa.
Common interview questions:
-What is the payoff of ELN?
-Why do investors buy ELN?
-What kind of options are involved to create a synthetic ELN?
-What are the risks for investors buying ELN?