If we were to break this down further, this product can be replicated by having the following in a portfolio:
- Buy a 3 months bond and
- Sell a 3 months put option on ABC with a strike at $8.
Why is the coupon paid by ELN higher than that of a typical bond or deposit with the same issuer and maturity? By replicating the portfolio, we can see that the investor is, in fact, selling a put option on ABC stock to the note issuer, and is compensated for the risk by receiving a higher “premium”.
Given two scenarios...
Scenario 1
If ABC falls below the Strike Price of $8, from a) you receive $10,000 from the maturity of the bond. But for b) you have to buy $10,000 worth of that stock at $8 regardless of where the stock is trading at as the counterparty will exercise the in-the-money put option.
Scenario 2
If ABC closes above the Strike Price of $8, from a) you receive $10,000 from the maturity of the bond. On the other hand, from b) you would have already received the premium from the moment you sell the put option. You’d have received $299 and put it into the bank for a 3-month deposit @ 1.3% p.a. To sum up, after 3 months you will get your $10,000 back from a) and $300 from b), totaling $10,300.