Thursday, June 04, 2009

It is easy to be cheated (5) - Equity linked notes

An equity linked note is created by a financial institution and usually takes the following form: the capital is linked to a specified share or basket of shares. If the share stay above a certain price during the specified , the investor gets a specified interest rate, which is higher than fixed deposit rate. 
If the share fall below a certain price, the investor has to take delivery of the share. The investor is told that they can keep the share until it recovers in value. The investor is happy to hold the share for the longer term, as it is from the shares of a reputable company.
This is how the investor can be cheated. If the share price goes up 10% during the period, the investor gets the specified interst rate, say 2%, and the remaining 8% goes to the product issuer.  If the share price drops by 10%, the investor has to bear the paper loss of 10%. 
There is no way for the retail investor to know if the terms of the transactions are fair, taking into account the relative probability of a gain or loss. 
Many people have lost a lot of money on these equity linked notes when the market gains against them. If the market goes in their favour, the only receive a part of the actual gain. 
To make the matter worse, the financial institution offer to lend money for the investor to take five times of the exposure. The investor is not aware that their risk has increased five times due to the leverage. If the share price drops 10%, they could lose 50% of their capital. They do not get a commensurate return if the share price moves in their favour! 
 Tan Kin Lian



Anonymous said...

Very well and clearly described. Short and brilliant!

It's great to be a bank! But maybe not so nowadays!

Anonymous said...

This amounts to cheating. Hope MAS will do something about it.

Demystified said...

There's a place for instruments like Equity Linked Notes.

Not in the way you'd described, which is that the Bank structured this simply to cheat people of their money.

ELNs offer a cheaper way of potentially buying the stock.

If you feel the stock will appreciate in 1 month, by all means buy the stock direct.

But if you feel the stock will trade sideways, and yet don't mind buying the stock for long term, BUT would not wish to buy at current market price, then ELNs are for you.

Of course you can suffer downside if the market collapses. It's the same risk as if you had bought the share directly.

The only difference is you do not share the upside if the stock outperforms. That's why you're compensated a little with a higher yield.

BUT, this is where your reading of the market comes in.

ELNs are good in a sideways trading market. Not otherwise.

Do not dismiss the instrument with a broad brush. It has it's merits if you possess an understanding of how it works vis-a-vis the market.

Thank you.

Anonymous said...

The worst thing about these equity notes is that usually a foreign bank will be the issuer and the banks selling the notes only earn a small percentage of it.As it is issue by the foreign banks the money will usually onverted into US dollars and even for the listed in the Singapore Stock Exchange it will be purcahsed in US dollars instead of Singapore dollars.Thus we will have to take both currency risks besides the price of the share.The bankers usually did not highlight the first risks or even mentioned about it at all.That is what happen to me. Thus my advice to people is to ditch the bankers and do your own investments by buying your good shares on your own or unit trust thru any security trading company.The return is much higher ,flexible and you wont get cheated by bankers (recall the minibond cases) further.They do not deserve to earn anything from our hard earn money.

Frustrated said...

Yes, agree with Anonymous 4 Jun 10:44pm.

Please only invest in fixed deposits and shares, things you understand.

Do not try all those exotic instruments and then cry foul when you get burnt cos you didnt understand the exoticness.

Anonymous said...

To: Demystified,

You are right to say that the strategy employed by an ELN is suitable for those who has a view that the stock will trade side way and hence do not mind to earn some income but with potential upside cap.

But you are wrong to say that the ELN is the instrument to use. The strategy that you are thinking of is the covered call option which is a combination of a long position in a stock and a short position in a call. Sophisticated investors would just use the covered call option directly. They will not use an ELN because (1) Bid-offer spread is large due to commissions (2) You do not hold the stock and hence there is a risk that the custodian can run away with your stock even if you supposed to hold the stock in the event the stock price is below the strike price.

Unlike sophisticated investors (who are usually portfolio managers), the ELN are marketed to novice investors like the aunties, uncles and the grandpa. These investors unknowing are making a short position in call so as to provide these product manufacturers a hedge against the long.

Nightsky said...

I would agree that Anonymous is right that ELNs are usually not bought by sophiscated investors who understand options.

How "ELNs offer a cheaper way of potentially buying the stock" escapes me after factoring the non-transparent high commission paid.

ELNs like all structured products are basically complex speculative bets with high risk to principal when bets turn out wrong. And unlike owing underlying shares, upside is capped.

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