Principal Protected Equity Linked Structured Note

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The Chinese University of Hong Kong

Faculty of Business Administration

MSc in Finance

Principal Protected Equity Linked Structured Notes

Yuyin Sun

FINA6250: Fundamentals of Derivatives Trading Strategies
Term 1, 2012 — 2013

Introduction

The Principal Protected Equity Linked Structured Notes (PPELSNs) are one-year Hong Kong dollar investments that guarantee the original principal at maturity with up to 6.8% annual interest payments. The PPELSNs are composed of zero-coupon bond and specified equity-linked option combination. With a guaranteed principal amount return, annual interest, if any, is paid based on the stock performance. A minimum investment size of $1,000 is required for PPELSNs. Detail features of this produce are illustrated in the following sections.

Target Customers

In the bear market, investors prefer secured investment portfolios. Since the PPELSNs are principal protected with derivatives embedded, the target customers are those whose investment preference is relatively conservative with primary investment goal of inflation protection.

Components

Zero-Coupon Bond: One of the components in PPELSNs is a zero-coupon bond with one-year maturity and 4% interest rate sold at $961.5. On the maturity date, the investors can receive $1000, which is the full amount of their principal.

Embedded Derivatives: After striping the discounted value of the zero-coupon bond, the rest of principal are invested into a series of long condor equity-linked options.

Underlying Asset: As the condor options are constructed, the underlying asset of this product should be the stock with solid fundamentals as well as relatively low volatility. Therefore, under this rationale, Hang Seng Bank Ltd (11 HK) is selected. Hang Seng Bank (HSB) is one of largest listed companies and the second largest bank in Hong Kong in terms of market cap with major business activities including retail banking and wealth management, corporate and commercial banking, treasury services, and private banking. In addition, HSB has relatively low volatility with beta equals to 0.85. Therefore, HSB is an ideal underlying asset that meets our expectation of solid fundamentals and low volatility. Figure 1 shows the price changes of Hang Seng Bank over past three years.

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Figure.1 Price changes of Hang Seng Bank (2009/10 – 2012/10)

Call Option: In order to construct the long condor options, a combination of four different option calls (long a low strike in-the-money call, short a relatively higher strike in-the-money call, short a high strike out-the-money call, and long an even higher strike out-of-money call) is created. The long condor options keep the investments from potential downside risk in the bear market, although the yield of the portfolio may be restrained in a limited range. This combination perfectly meets the relatively conservative investment preference of the target customers.