Saturday, April 11, 2009

Equity Linked Notes - are the terms fair?

I was given the Security Purchase Contract Note for an Equity Linked Note. The contract note is very difficult to read, even for an expert like me. The Note was issued by bank X and distributed by bank Y to a Chinese educated elderly person (who does not understand English). 

After reading the contract note, I was able to analyse the terms as follows:
a)  The note is linked to two shares, A and B
b)  Interest is payable at an annual rate of 12% for each day that both shares stay above the trigger price (which is 85% of the reference price). If any share fall below the trigger price, interest is not payable for that day
c) At the end of each observation period (about two months), if both shares are above the trigger price, the Note is redeemed at par, plus accrued interest.
d) On the maturity date (18 months), if any share falls below 70% of the reference price, the investor is given the shares and has to bear the capital loss (of more than 30%).
e) The Notes are principal protected at maturity (provided the Knock-in event has not occurred). There is no mention of the party providing the guarantee, but a statement as follows: "the notebolder is exposed to the credit risk of the issuer or the third party guarantor".

I find this product to be unsatisfactory in the following respects:
1) The "interest payment" is not really "interest". It is actually a risk premium given for providing the insurance against a 30% drop in any of the shares in the basket.
2) It is impossible for the investor to know if the risk premium is fair, given the unknown extent of the risk?
3) The contract is designed by bank X, which stands to gain from the margin between the true cost of the risk and the so called "interest" payable to the noteholder. This can be to the disadvantage of the retail investor, and can in an extreme case, be considered as "cheating" the investor.

There are laws against creating gambling contracts, without approval of the authority. Does this type of equity linked note fall within the definition of a gambling contract? This law was written to prevent the public from being cheated.

Outcome: The issuing bank X went bankrupt. The investor lost the entire principal, amounting to several hundred thousand dollars. The distributing bank Y was negligent in exposing the investor to a large risk - without proper diversification.

If you are in a similar situation, with a similar product, you can write to me at kinlian@gmail.com.

5 comments:

Unknown said...

Looks like the products are gaming products. The distributors take your money and make bets and they share with you if they make enough and above. Your money and your risk.
Insurance products too are no different. For par products they use your premium to make bets and bonus is declared if they make enough to cover the salaries of the ceo and the senior management, and the agents.
Today these products are like gambling.

Jeremy said...

The retail investor is exposed to a significant portion of the downside risk in return for a potential 12% interest.

In issuers' favour is the following: If the equity market puts in a decent performance, Notes will be redeemed and hence, the 12% return will not be for the full tenure.

If however, equity market puts in a bad performance (>30% decline) at any point during an 18 month cycle, a considerably long period, the investor is left to hold the poor performing stocks.

Effectively the bank has bought market insurance from the retail investor. It is an extremely high risk product for most retail investors.

mw said...

The bank basically paid the investor for a put option.

Steve Wu said...

While there may be laws against disguising "gaming contracts" as financial products, there are also some related issues.

When one plays in a (fair) casino, the games are completely transparent in terms of the rules, the payouts, etc. It is gambling precisely because the outcome is unpredictable.

Some financial products may hold the risk of similar unpredictable outcomes. However, is the financial product as transparent as a casino game? Does the product marketing material highlight the key facts in the legal product description without deception, distortion or omission? Does the product distributor disclose the relevant risks, not just the potential benefits? If no, then there are certainly elements of cheating, a criminal offense.

Is it difficult to be transparent and truthful? As Mr Tan's product summary nicely demonstrates, not at all!

Will the retail investor still buy such a risky product in isolation (not for hedging) if he knows the truth? Is he told that the product is a good replacement for fixed deposits?

Falcon said...

I do not recommend gambling because one loses most of the time. But if you compare these products with gambling, then I will rather recommend gambling than this because at least in gambling, you get to win a the full amount if you win then only a fraction in these products. So in other words, you stand a fairer chance in outright gambling than in these products.

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