Introduction
Would you like to foray into the most flexible and viable form of investment? Would you want capital protection and returns on investment? Then choosing ELNS would be the best bet for you.
Equity-linked Notes also known as ELNs, are structured Notes that investors use to improve their returns on cash holdings especially when the markets indicate slightly bullish trends in stocks. We shall understand how is Equity Linked Note Pricing done by clearing the concept of ELN.
As ELNs are a popular form of structured notes, their structure comprises fixed-income securities and equities. ELNs provide a regular source of income by giving away coupon payments to investors. At the same time, these equity-linked notes provide substantial returns on investment if the underlying assets the notes are linked to, perform well in the market.
Equity Linked Note Pricing
The Valuation of ELNs is done using two main methods. Let us have a run-down into the same:
Discounted Cash Flow Method
The Discounted Cash Method, also known as the DCF method, calculates 95% of the initial price offering and then disburses the amount to the investor at the time of maturity of the note.
However, here is the catch. The 95% initial pricing is given at the time of maturity only if the strike price or call price doesn’t fall below the intrinsic value of the ELN.
On the contrary, if the strike price hikes due to the superlative performance of the asset the ELN is linked to, then investors are offered a complete value of their principal amount.
The difference between the principal amount paid out and the initial amount paid out by the investor represents the yield of the ELN. The credit risk and secondary market risks are to be considered when investors invest in ELNs. The note may be linked to the performance of the underlying assets and
Illustration of the Concept using a relevant case study
The investor initially buys his ELN for $16, Let us see how yields change over the maturity of the investment. The valuation date may differ on a case-to-case basis
- Spot price of the underlying shares for the note issued = $16.00
- Strike Price = $15.20 and the
- Strike Rate= 95%
Scenario A
If the market price share goes above the spot price/ strike price or call price, the investor will receive $16.80 (16= Value of the Principal amount; 80 cents is the yield of the investment). As you hold a higher number of shares, the value of your investment portfolio increases.
Scenario B
If the underlying equity goes below the strike price or call price on account of poor market conditions, then investors receive $14.20 (Principal amount – discounted rate). The risk associated with the investor losing a portion of his/her capital amount is higher. Here, the stock price closes below the call price. This type of structured ELN is a non-capital-protected one as the risk profile lies on the onus of the buyer.
Scenario C
When the underlying equity options for the investment product fall to zero, then the investor may lose the complete value of the investment. The volatility or risk in this financial instrument is therefore pretty high
Here is a statistical chart that depicts the same:
Black Scholes Option Pricing Model
This is the 2nd method by which ELNs are priced or valued. The equity-linked note pricing is done by calculating the embedded values of the instrument.
In other words, The investment banker calculates the fixed component of the note and the equity portion of the note to determine the value of ELN.
By taking the embedded values of the instrument, the final pricing of the ELN is being arrived at.
Illustration of the Concept using a relevant case study
Suppose the investor gets himself an ELN that comprises a debt fund valued at $10 per offering. And, the asset value of the ELN is valued at $20 per offering, let us now see how the calculations are being done:
Embedded value of the Debt Fund= $10
Embedded Value of the Investment or Asset fund (Equities or Stocks) = $20
Net value of the ELN= A + B which is $10 + $20= $30
Types of Equity Linked Notes
We have seen two comprehensive methods of how equity-linked note pricing is done. Now, let us have a brief overview of the types of equity-linked notes or ELNs!
Principal Protected ELNs
As the name suggests, you have protection on your initial investment or your capital amount. This is regardless of how the underlying asset performs in trading.
Traditional or conservative investors like to invest in principal-protected ELNs as they can receive their principal money back. At the same time, they can also receive the add-on income the assets earn on their investment from the equity market. The earnings can be interest income and equity index values hiked up here.
Non-Principal Protected ELNs
These are ELNs whose returns on investment solely depend on the performance of the underlying assets to which the notes are linked. If the underlying assets do well in equity, then the investors receive higher returns on their capital investment.
On the contrary, if the asset value depreciates or fails to pick up in the equity markets, the investors can lose the entire portion of their initial investment or capital amount.
Although the non-principal protected ELNs offer the potential to earn higher returns, these instruments also carry higher risks of losing capital than the principal protected ELNs. The investment objectives of different investors operate vividly.
Hybrid ELNs
Hybrid ELNs combine the features of principal-protected and non-principal-protected ELNS. The investors receive a portion of the capital if the call price or strike price goes below the expected value of the underlying assets.
On the other hand, if the asset performs over the strike price or call price, then investors receive their capital plus the yield of their investments.
As hybrid ELNs have flexibility concerning their structures, investors can manage their risk portfolios using customized investment preferences. The investment decision to pick hybrid ELNs also depends on the risk tolerance of every individual investor.
Unveiling the components of ELNs
As we have already seen the definition of an ELN is. It is a component that comprises fixed-income securities and asset allocation units.
Let us now see what the fixed income components are and what the variable or asset components are.
Fixed Income Component
In a typical ELN, you have a fixed component that is attributed to it. Let us deep dive into what the features of a Fixed Income Component are:
Bond- A bond is usually a note or a fixed debt instrument that is issued by a financial corporation or an institutional bank. The fixed income component of ELNs provides a regular source of income through coupon payments.
Coupon payments- When the investor buys ELNs that have a strong presence of the debt component, then interest payments are regularly paid out to the investor. These are known as coupon payments.
The frequency in which the coupon payments are paid depends on the ELN Issuer and the specific terms and conditions that are mentioned in the document.
Maturity Date- The maturity date of the ELN is specified on the initial offering itself. Investors either receive the entire sum of principal at the time of maturity. Otherwise, they receive a portion of their initial investment amount at the time of maturity.
If the underlying asset performs too well in the equity market, the additional returns are added to the principal money, and disbursements are made to investors.
Equity Linked Component
These are the structural elements of an equity-linked component that the ELN carries. Let us have a look into the same:
Underlying Asset- The underlying asset can be an equity or a stock-value index. The asset can be a single stock, a basket of shares, or stock indices.
The ELN’s Return on Investment is tied to the performance of the underlying asset of the note. In other words, the price movements and performance of underlying assets directly impact the value of the ELN that accumulates during the time of maturity.
Conversion Ratio- Conversion ratio refers to the proportion of the asset value an investor earns at the time of maturity of the asset. The ratio determines the upside performance of the asset values from the equity-linked component of the ELN.
Option Structure- Call/Put- ELNs can be linked to shares or securities with call or put options. The investor therefore receives an opportunity to buy or sell the underlying assets at pre-determined prices on or before the dates as specified on the offerings document.
The presence of an options structure can significantly impact the Return on Investments of ELNs and alter the risk-handling portfolio too.
Key Takeaways
ELNs are thriving investment options for retail as well as institutional investors. Investors who want to discover a diverse opportunity to receive investment returns via fixed payouts, as well as the underlying asset’s performance indexes through Equity securities, opt for ELNs.
ELNs lend potential return on investment portfolios by combining the features of fixed-income securities, underlying stocks, and equities. The dividend and stock price hikes are added to the investor’s closing price amount.
Higher-interest financial products are meant for investors who can handle better risk tolerance. The direct investment vs variable interest rate differs from one product to another.
And, investors can choose from a wide variety of options such as principal-protected, non-principal-protected, and hybrid ELNs. They can pick one of the three that aligns with their risk tolerance and financial goals.
However, investors need to understand the potential risk factors or the downsides that are associated with ELNs. You must also be fairly conversant with regulating bodies that issue ELNs. Getting exposed to the credit risk of the issuer can also be on the cards.
By seeking expert guidance from wealth or investment managers, you may quite understand what fits for you and what doesn’t. This way, you can position your structured product portfolios indicating long-term financial success and growth.
