5.3 PRODUCT MECHANICS AND APPLICATIONS
5.3.5 Equity-linked notes
Equity-linked securities are floated in a variety of forms, including FRNs and bonds (primarily via MTN and EMTN programs in order to reduce costs/time)16 with embedded derivatives referencing individual equities, baskets/sectors, or indexes. Though the embedded derivatives can take the form of equity forwards, swaps, and options, the latter tend to be most popular.
This is because options are unilateral contracts, so cash flows can be controlled more precisely;
in addition, the growing range of exotic equity options (e.g. barriers, digitals) means that highly bespoke risk profiles can be created for investors. In fact, notes can be created to give investors bullish or bearish views on market direction or market volatility.
16Public deals issued via shelf registration need only adhere to the prospectus supplement requirement, rather than a full prospectus.
Figure 5.5 Equity-linked note. * Principal redemption increased if option moves in-the-money; interest coupon decreased as a form of premium payment
An investor in a basic equity note purchases a security that pays no coupon (or a below- market coupon), in exchange for appreciation (e.g. a call) or depreciation (e.g. a put) in the equity reference. The redemption of the note typically is set at par (i.e. a minimum guaranteed fixed payment) plus a percentage of the appreciation or depreciation in the reference equity index.17 The issuer of the note, such as a bank or company, benefits from a lower cost of funding through the receipt of the premium payment (e.g. the zero coupon or below-market coupon rate on the note). As with the other notes mentioned above, the issuer may purchase a similar/identical option in order to monetize value. Figure 5.5 summarizes this structure.
Creating this type of equity-linked security follows a multi-step process that begins with computation of the issuer’s funding level. Once the target level is known, it is converted into a fixed rate covering the term of the note; this generates the value of the implied zero coupon bond. For example, if the funding level suggests a 75 % zero coupon threshold is required,
$75 of each $100 of note proceeds is used to purchase a zero coupon, which grows to $100 by maturity. The balance of the note proceeds is used to acquire an option (e.g. a call). With a market value on the option of $20, the maximum amount of call coverage is $25/$20, or
$125 per $100 of note issuance. In practice, some amount of the remaining $25 balance must be used to cover issuance fees and/or to pay an interim coupon (on nonzero coupon deals).
It is easy to see that if principal protection is reduced (e.g. the $100 is not guaranteed at maturity), larger coupons and/or larger participation can be introduced into the process. In fact, the coupon/principal value of the note is a function of interest rates, maturity, option moneyness, option volatility, and desired level of equity participation. A note with an out-of- the-money equity option commands less premium (and thus more coupon), but also provides less upside potential; one that is at- or in-the-money commands a greater premium (and thus a lower coupon), but supplies a larger upside potential. In general, as moneyness increases, the participation rate increases; the same is true if volatility increases. For example, a note might feature a five-year maturity and a 2 % semi-annual coupon plus 90 % of the appreciation in the S&P 500 above a strike price of 650, with a minimum redemption of par (i.e. no principal at risk). The investor retains $0.90 of every dollar after the S&P exceeds the 650 strike. In the
17In some cases, the appreciation/depreciation is paid via an enhanced coupon as it is accumulated, rather than via principal redemption.
opposite form of this structure, investors write the issuer equity calls or puts in exchange for a higher coupon. For instance, under a call-based note, the investor receives a higher ongoing coupon, but smaller principal redemption, as the equity reference rallies above the strike:
P*
Indexmat−Index0
Index0
where
Pis principal
Indexmatis the index level at maturity Index0is the index level at trade date.
The issuer of the note, which owns the underlying call option can, of course, hedge itself and monetize value by selling a similar or identical call at a higher price.
Put-based structures tend to be less popular than call-based structures, as investors often prefer to participate when markets are in an uptrend. This suggests that put-based structures may be cheaper, allowing a greater level of embedded investor participation. Other types of equity notes can be created, including those with synthetic collars, where an investor receives both a minimum and a maximum return; the investor is thus long a put and short a call via the note (meaning, of course, that the issuer is short a put and long a call). The note can be
“tranched” by allowing investors to select from a series of preferred ranges (e.g. minimum 5 %–maximum 10 %, minimum 0 %–maximum 18 %, and so forth); these tranches represent collars with different strikes. Figure 5.6 illustrates the collared equity note.
In a similar fashion, coupons may be embedded with call spreads that set minimum and maximum boundaries for a particular quarter or semi-annual period (e.g. minimum appreci- ation of 1 % and maximum appreciation of 5 % in any quarter); the short call on the upside (e.g. sacrificing gains above 5 %) increases the investors’ participation rate. Other notes may feature embedded cliquet/ratchet options that lock in unrealized value, even if markets subse- quently retrace; more extreme versions feature lookback options, supplying investors with the maximum gain achieved during the life of the transaction. Any option structure that features such “enhanced” profit opportunities is likely to be more expensive than one with a vanilla option.
$ Call Call premium
FRN issuer P&I
Put premium Put Investor
Figure 5.6 Equity note with embedded collar
Another form of equity-linked structure is the synthetic equity warrant, also known as a cov- ered equity warrant (this warrant is distinct from the bond/equity warrant package we describe in Chapter 8, which is an instrument that leads to the flotation of new shares). The synthetic warrant is akin to a long-dated third party call (or put) option that can be floated independently, or embedded in a host note. The original synthetic warrant structure was developed in the Euromarket of the 1980s, when Swiss investors sought a greater amount of participation in the Japanese markets without assuming any currency risk. Accordingly, US investment banks issued Swiss franc denominated synthetic warrants to investors, and hedged their exposures through a combination of the actual dollar or yen warrants and foreign exchange contracts.
Since that time, equity warrants have expanded to include a variety of options, including knock-outs, lookbacks, and spreads.
Equity-linked structures generally feature a modest level of secondary liquidity, primarily from the underwriters/dealers responsible for structuring the deals. In general, however, the securities are intended as “buy and hold” investment strategies. Publicly issued notes are listed on one or more exchanges; those that are listed must adhere to specific exchange requirements related to minimum distribution size, financial standards, and so forth.