Introduction
In today’s technological world that you live in, the world of investments and finances has gone through a paradigm shift indeed. You need not go through fixed investment options anymore.
You can discover tailor-made solutions concerning your investments. Plus, you can tell an investment banker that you have structured requirements to take care of and you can have an investment portfolio built for you based on the customized set of requirements you have in mind.
Such an option is called ‘structured notes’. These are notes that are designed for the investors based on their independent financial requirements they have on mind. These notes combine a mix of debt and equity. You can leverage options so that they help you achieve your financial objectives seamlessly.
On this note, let us discover how equity-linked note knock-in works while giving you an understanding of the revolving specifics too.
What Are Equity-Linked Notes?
Equity-linked notes are structured notes that link debt with equity assets. The notes are issued in the name of the investors and the returns of investment are linked to the performance of equity assets that the notes are linked with.
The equity asset allocation comprises shares, bonds, the basket of securities, and other components that belong to a broader market index. Equity-linked notes are popularly known as ELNs.
Concerning ELNs, the returns of investment are not fixed or static as in the case of fixed-income securities. The returns of investment are linked to the performance of equity-based assets of the notes. Therefore, the returns upon maturity, cannot be pre-determined as in the case of bonds or fixed-income securities.
ELNs can be principal-protected or non-principal-protected. Principal-protected ELNs promise investors a return on their capital investment despite the volatile conditions of the equity market. However, non-principal ELNs do not guarantee a return of capital to investors.
Knock-In- Meaning Explained
Structured notes utilize trading barriers, caps, and floors to provide downside protection against an investor’s capital investment. However, when market conditions are adversely impacted, the investors might lose a portion of or an entire amount of capital investment.
In this parlance, a knock-in refers to a feature wherein a conditional feature or a barrier is added to a structured note as such. Here, the note gets activated only when certain market conditions or barrier limits have been met.
This way, a knock-in structured note starts paying interest yields or principal deposits only if the underlying stocks of the notes drop below predetermined levels. This knock-in adds a protective layer as investors get favorable returns if the knock-in conditions are met. On the contrary, the investor might receive losses if the market conditions do not satisfy knock-in limits as preset on the notes.
In general, a knock-in feature is added to a structured product to mitigate losses or gains for the investor, and the feature is added to tailor the investor’s risk-handling appetite.
Equity-Linked Note Knock-In Features Explained
These are the following features of Equity Linked-in Note Knock-in. Let us have a run-down into the same:
Structure of an ELN
An ELN comprises a fixed component like a bond and an equity component like that of a stock or derivative. The ELN usually offers interest earnings or dividend disbursements in the form of coupon payouts and the returns here are usually higher than traditional investments and fixed-income securities.
Knock-In Feature of the ELN- Working Mechanism Explained
A knock-in feature usually refers to a preset barrier or a knock-in limit as has been set upon a structured note. When the barrier limits knock-in, the note converts into an equity-linked product. This is how a knock-in ELN typically gets activated.
Scenario Explanation Of How A Knock-In Operates
For a knock-in feature to get activated, the barrier limit must be breached. Say, for instance, the structured knock-in is at $50, the note gets converted into an equity-linked note only if the underlying stock price of the note touches or goes below $50.
What Happens If A Knock-In Barrier Is Breached?
If the knock-in barrier is breached, the knock-in activates in the ELN, and payouts are linked to the performance of underlying stock prices the ELN is linked to.
On the other hand, if the knock-in barrier is not breached, then investors get the regular coupon payments and principal the note would otherwise generate. Here, the structured note does not convert into an ELN.
Risks Of Knock-In ELNs
If the knock-in equity-linked notes do not perform well in the market, then investors can lose significantly because of the leveraged action. This happens if the equity assets fail poorly in the market post the knock-in.
Returns For Knock-In ELNs
The returns for potential knock-in ELNs are usually higher than fixed-income securities as these products come to you with an optimal level of equity risk exposure. Therefore, even with increased market volatility, the leveraged feature of this variant of ELNs mitigates the overall losses for the investors.
What Are The Benefits Of ELNs?
These are the overall benefits of ELNs:
Higher Returns On Capital Investment
The potential returns on investment for ELNs are higher on the cards. This is because the notes are exposed to equity-based assets like stocks or high-paying securities that can get higher returns in favorable markets. Therefore, ELNs fetch better rates of returns over traditional bonds or fixed-income securities.
Gets You A Diversified Form of Investment Portfolio
ELNs provide exposure to a wide variety of investments like stocks, shares, bonds, and other financial products with broader market indexes. Therefore, having a few number of ELNs gets you a diversified investment portfolio as compared to investing in individual stocks.
Wide Exposure To Underlying Assets
ELNs help investors get wide exposure to equity-based assets like stocks, shares, currencies, market indices, and the basket of high-paying securities, to name a few. Therefore, even if the investor possesses a limited number of ELNs, he gets a wider exposure to equity markets as compared to direct investments with similar investments.
Highly Customizable
ELNs are highly customizable and therefore offer tailor-made solutions to meet investors’ independent financial goals or objectives to be specific.
Here, you can avail customized ELNs by tailoring the notes according to each investor’s risk tolerance and investment handling appetite on the whole. You can also get customized returns in the form of interest payouts, coupons, or dividend disbursements.
Therefore, ELNs offer great customizable options to build their structures and also provide you with lucrative returns on investment.
Risk Factors Of ELNs
These are the overall risk factors that are connected with ELNs. Helping you through a run-down into the same:
Market Risks
ELNs are subject to a wide variety of market risks. This is mainly because the underlying assets of ELNs are equity-based. These assets are predominantly exposed to the volatility of equity markets. Therefore, equity-linked notes are subject to market risks on the whole.
Credit Issuer Risk
As investors, you must make sure that you purchase your ELNs from credible financial institutions or from investment-grade banks that are of a high caliber. This is because when you purchase your ELNs from mediocre financial agencies, and they sign up for their insolvency, then investors can lose the entire portion of their capital investment.
Currency Fluctuation Risks
ELNs can be linked to a wide variety of equity-based assets like stocks, shares, a basket of securities, and currencies to name a few. High-paying currencies like US dollars or Euros are subject to currency drops or hikes due to volatile market conditions. Therefore, ELNs are subject to currency fluctuation risks on the whole. The investors therefore must read disclosure documents of financial instruments like ELNs before they would want to invest in the same.
Suggested Reads: Understanding the different investment options for ELNs
Valuation Methods of ELNs
ELNs have two main types of valuation methods. These are:
- Discounted Cash flow method or the DCF method and
- Black Scholes method of pricing.
Discounted Cash Flow Or The DCF Method
The Discounted Cash flow method or what is commonly known as the DCF method involves projecting future cash flows to arrive at ELN values. The ELNs are then discounted to their present value using a specified discount rate as is applicable here. The difference in pricing values determines the rate of investment the ELNs can garner for investors on the whole.
Black Scholes Method Of ELN Pricing
Under a Black Scholes method of pricing, independent values of underlying stocks or equity-based assets are calculated. The value of the embedded bond component is also calculated. By combining the value of the fixed component with that of the equity-based derivative, the final values of ELNs are finally arrived at. Investors get intrinsic values for ELNs using the Black-Scholes method of ELN pricing.
Suggested Reads: Discover an entire know-how on equity-linked notes
How Are ELNs Utilized By Different Segments of Investors?
ELNs are usually bought by three segments of investors on the whole. These are:
- Institutional investors
- Retail investors
- Corporate entities
Let us see how ELNs help each of these segments in raising their capital requirements or investment portfolios.
Institutional Investors
Institutional investors are pension fund managers, insurance companies, and asset managers on the whole. Institutional investors utilize ELNS to enhance portfolio holdings, diversify returns on growing investments, and manage asset liquidity on a more enhanced note.
Retail Investors
Retail investors are posh individual investors who love investing via sophisticated investment products like ELNs. These individual investors buy ELNs to get wide exposure to equity-based assets, build healthy investment portfolios, and customize their risk-return profiles according to their tailored financial goals/ objectives.
Corporate Entities
Corporate entities use ELNs to raise capital requirements from the public while offering them potential investment opportunities too. ELNs have notes linked to equities, stocks, and bond options. This way, more investors are lured to potential returns on investment while helping the corporate entities raise their capital requirements on a hassle-free note.
Tax Implications of ELNs
Here are different types of tax implications that apply to ELNs.
Interest Earnings
ELNs earn interest payments via the fixed component of these structured notes. The interest earnings can be taxed according to the jurisdiction where the investors reside and based on how tax implications apply to the residential countries they are from.
Capital Gains
Sale proceeds of ELNs can be considered for capital gains computation. Here, capital gains are included in tax slabs according to the jurisdiction where the ELNs were issued and based on the residency status of investors who purchased them.
Dividends
ELNs might provide dividends based on the earnings from the underlying assets that the notes are linked to. The tax treatment of dividend earnings depends on the jurisdiction wherein the ELNs were issued and on the tax implications norms of the investors’ residence.
Suggested Reads: How is equity-linked notes pricing done
The Bottom Line
Equity-linked notes provide a diversified investment opportunity to investors by combining the power of fixed-income securities with that of equity-based derivatives. This way, investors can enhance their portfolios and earn better returns on investments over traditional investment options.
Frequently Asked Questions or FAQs
How does an asset value be rendered worthless?
Answer: An asset value can be rendered worthless if the strike prices go below pre-determined barriers or initial purchase points that have been preset on structured notes.
What is a bullish market?
Answer: Rising markets in the equity setup is what is known as a bullish market.
Does ELNs offer initial investment to investors upon maturity of the notes?
Answer: No, ELNs are based on the performance of underlying equity assets the notes are linked with. Investors earn better interest rates or coupons under favorable market conditions. However, implied volatility in equity markets may cause investor’s assets might expire worthless. Here, they might lose a portion of or an entire portion of their initial capital investment.
Can you hedge ELNs?
Answer: You can get in touch with the product issuing firm to add leveraged features like hedging, knock-in, or knock-out to your ELNs.
Investors must read offer documents carefully before signing in on the dotted lines.
