Equity Linked Savings - A New Twist
Team Latte
Feb 06, 2005

Currently the major Asian stock markets have reached a plateau and many expect that after a breather the markets will go up again. There is a school of thought that in the medium term, say three to five years, the stocks will go up much higher than the present level. Also, rightly or wrongly, the general feeling amongst retail investors is that the interest rates will not go up at the pace that many were expecting in the beginning.

Under such circumstances the banks and the financial institutions (sell side firms) can consider an equity linked savings product for retail investors in Hong Kong that takes advantage of the above retail investor sentiment.

A product can be designed whereby a retail investor - an individual investor - pays to the bank a monthly installment of US$300 per month for the next 36 months (3 years). The bank in return lends to the investor an amount equal to US$44,000 up front (right at the beginning of the purchase of the product) to be invested into a basket of three high yielding Hong Kong stocks (stocks with high dividend yield, like Hong Kong, Cheung Kong, etc.). Dividends are not passed on to the investor, but retained by the issuer of the product.

What does the issuer (bank) get out of such a deal? How much money does the issuer make?

Let's check the payoff of a product like this:

Pay - off = N * Index₃ - $44,000

Where, the basket value of the three stocks is taken as the Index value. Here, N is equal to $44,000 divided by the value of the Index at start (t=0).

The seller (issuer) of the product, the bank, will need to hedge this product. The first part of the above payoff equation can be hedged by buying N shares of the index. The cost of doing that is N*index (t=0) minus the present value of the dividends. If we assume a dividend yield of 3.15% for the Hong Kong stocks chosen in the basket and assuming that the bank can get funding at 2% the present value of the dividends is $3,916. But since N = $44,000 / Index_t-0, the bank will need around $40,084 to hedge the first part of the above payoff. The second part of the payoff can be hedged by borrowing the present value of $44,000. With 2% funding rate this comes to $37,671. Therefore the total outflow to the bank from the above payoff will be equal to $40,084 minus $37,671 which is roughly equal to $2,414.

The inflow to the bank - seller of the product - is equal to the present value of the 36 installment payment of $300. This is the amount of money that the bank received from the buyer - investor - of the product. This is roughly equal to $10,477.

Hence the net profit to the bank is equal to inflow minus the outflow which is equal to $8,063. This is a humongous gain by the seller of the product!!

If the funding rate for the bank is 3% then the gain would be around $6,680 and at 4% funding rate the gain for the bank will be $5,337. In any case the issuer of such a product stands to make a lot of money from the investors.

(The above is based on a real life example a similar product introduced in The Netherlands a few years ago and as reported in Henry M. Kat's Structured Equity Derivatives.)

Disclaimer
"Risk Latte uses proprietary and non-proprietary mathematical and empirical models to measure the volatility and estimate the direction of the market. There is no guarantee of any particular outcome happening and readers must exercise caution while interpreting the conclusions of this article. Risk Latte Company is not a registered stock broker or an SFC registered entity and readers must take advise from their financial advisors, stock brokers, research analysts and bankers while making any buying or selling decisions. Risk Latte Company is not in the business of making stock or asset forecasts whether explicitly or implicitly and shall not be responsible for and/or liable for any losses arising out of any trading decisions based on the above article."

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