Equity Linked Notes

Why Equity Linked Notes?

In simplified view, the classical banking business consists of two kinds of business:

• Customers who have money deposit it and get interest as a compensation.
• Customers who need money get credit and pay it with interest.

The interest for saving is lower than the interest for credit and this difference (and some other provisions and fees) founds the profit of the bank. In addition to this classical business, which we may call money and credit trade, the banks have developed a new business in the last 20-30 years: risk trade. Under the risk we understand, the risk that the price for something will rise or fall in the future, and we don't know, which direction the price will take. The business follows the same pattern, as by savings and credits:

• Customers who want to hedge against the unfavorable price movements or who want above average profit from favorable price movements, may buy an option and pay it with option premium.
• Customers who are willing to take higher price risk, may sell to bank an option and get paid by its premium.

In the second group there is a problem for the bank: how can the bank be sure, that the willing-to-take-risk customer will pay his or hers gambling debts on the end? This problem, also known as counterparty risk is solved in three ways:

• By huge customers like states, other banks, etc., the possibility that the customer wan't pay is considered as very low and the risk is simply accepted.
• One can arrange that the customer pay his or her gambiling debts on some regular basis (daily, monthly), or that the customer deposit something valuable (collateral) by the bank during the contract. The rest risk for the bank is then minimal, but the administrative effort is high.
• One boundles the sold option together with some other finance contract like e.g. upfront deposit of the maximal possible loss, so that on the end of the contract, only the bank can be the one, who has to pay something. Such structures are called notes. If the notes risk is linked to equity price movements, then the structures are called equity linked notes.

What exactly are Equity Linked Notes?

Equity linked notes usually are debt obligations of the issuer bank. Their main characteristics are:

• Notes usually have maturity.
• During their lifetime there may be some coupon (interest) payments to the holder.
• On maturity, the amount which bthe issuer pays depends on the closing price of the underlying instrument.

Example:
If the closing price of the Daimler Stock (DE0007100000) on Xetra on October 31st is higher than 60 EUR, the holder of the note receives 60 EUR. Otherwise he or she recives the closing price of the stock.

On German market there are currently more than 400 000 different equity linked notes. A summary can be found on e.g. http://zertifikate.finanztreff.de/ (only in german).

Should one buy such things?

Yes and No! In each case, one should know what he or she is doing. The main things to consider are:

• By buying the note one buys the risk. This means, in most cases everything goes well and one gets the premium, but sometimes one has a bad luck and get a loss.
• Notes always have maturity. One can often right predict the future market trends, but it is much more difficult to predict when the market change will happen. If the right predicted change enters after maturity, then one has lost although the prediction was right in kind.
• The note is a bet. If the one wins, it must be someone who has lost the same amount.
• The issuer is secured against the default of the buyer because the buyer has already paid the highest posible lost. The buyer of the note is not secured against the default of the issuer: in case of bancrupcy he or she gets (almost) nothing. Fortunately, the bancurupcy of the issuer (usually bank) is very seldom.

Equity Linked Notes from the issuer point of view

From the issuer point of view the equity linked notes are profitable buisiness for the following reasons:

• The issuer (usually banks) sell the risk and so they may save the regulatory required capital or take the risks somewhere else.
• They may relatively easily completely hedge the market risks through dynamic buying of underlyings.
• The counterparty credit risk is mitigated.
• The margins are relatively high.
• The issuer banks controll the market: In the beginning, immediately after the issue, there are more buyer than seller and the price is high. Later, there are more seller than buyer and the price falls. Only on maturitzy, the price is fixed.

Types of Equity Linked Notes

The most common types of equity linked notes are:

• Discount Notes
• Bonus Notes
• Autocallable Notes

These three types will be discussed hier in the next couple of months.