Protected Equity Notes
Suppose you are an analyst working for the Sacramento County Public Employees’ Pension
Fund (SCPEP). The fund has $10 million invested in a Japanese stock market index mutual
fund. Currently the dividend yield on the stocks in the Japanese index is 0.5% annually. SCPEP
has been approached by Bankers Trust with an offer to arrange a bond issue with principal of $5
million, a 1% annual coupon, and a maturity payment at the end of five years that will be
determined by the appreciation in the Nikkei Dow Index of 225 Japanese stocks. The formula
for calculating the maturity payment is as follows:
Maturity payment =
Principal * (IT/I0 ) if the index increases, with guaranteed return of
principal if the index declines.
• IT = the Nikkei index at maturity and
• I0 = the Nikkei index at origination
The bond will be issued by Private Export Funding Corporation, whose debt is
guaranteed by the Import/Export Bank of the United States. PEFCO has AAA bond rating, and
would arrange a swap through Bankers Trust that would allow it to pay a fixed annual interest
rate over the five-year period and receive a variable amount equal to the notional principal times
(IT/I0 – 1). Thus there is virtually no risk of default. So, it appears that this so-called “Protected
Equity Note” (PEN for short) is a better investment than the Japanese index mutual fund. Your
boss wants you to analyze this PEN and report back with a recommendation and an explanation
of how it works.
Prof. Kensinger
Practice Problem