Introduction
With so many websites offering financial products, you also find that these sites mention too much jargon that you are not able to understand. Therefore, web users eventually close off the pages not able to figure out what lies where.
The investors therefore get confused. On the other hand, when you break down the concepts into simpler terms, even a layman finds it easier to understand.
For investments, it involves your hard-earned money. The more of a breeze it is for you to understand what investment products are and what they offer you in a nutshell, the easier it gets for you to make well-informed investing decisions for you and your family.
On this note, let us discuss mainstream equity-linked note valuation methods while also giving you a touch-down into the product’s basics.
What Are Equity-Linked Notes- Meaning and Conceptualization Explained
Equity-linked notes are structured notes wherein the returns are linked or tied to the performance of underlying equity-based assets that the notes are linked to.
The asset classification comprises individual securities, a basket of securities, or broader market indexes. These notes are primarily linked to the equity market or the derivatives market.
Equity-linked notes are popularly known as ELNs. These notes predominantly have the price of the underlying assets as the benchmark for determining the returns that the investment portfolio gains over the term of the asset. These notes however come with principal protection bonds and the investors receive their principal money during maturity.
The yields can be higher than traditional bonds or fixed-income securities as the returns are linked to the upscale performances of underlying equity assets. As ELNs depend on the performance of equity assets, it is well understood that investors are not going to get fixed sources of income. The payouts are variable.
As ELNs are structured products that promise principal protection, the investors have a safety net against their capital wording even if the markets fare poorly. Therefore, this is an attractive source of investment to be in. In a nutshell, you can fairly conclude that ELNs offer capital protection while the returns on investment or the yields are dynamic owing to the rise and fall of assets in volatile market conditions.
How Do ELNs Typically Work?
ELNs represent a unique category of financial instruments. The investors may get fixed-return payouts like coupons or interest earnings typically the way traditional bonds or fixed-income securities do. This is because the debt component protects interest payouts and also lends principal protection to investors. This is possible only if the clauses are stated on the initial screening documents.
On the contrary, as these are investment bonds tied to underliers belonging to the equity or derivative markets, you cannot determine fixed returns at the end of the investment term just as in the case of government-aided bonds, fixed annuities, or mortgages.
Instead of fixed-interest or coupon payment models, the returns of ELNs are pretty dynamic. Investors receive their final payout in the form of their initial investment amount or the deposit they made when they signed up for this portfolio. Alongside, the returns are based on the performance of equity-associated underliers and this payoff depends on the performance of the underlying assets during the entire tenor of the asset.
ELNs are also short-term investment options usually spanning 1-4 months and these notes are held until maturity and the linked-in assets are not actively traded in the secondary market.
The ELNs therefore cater to a wider range of investor preferences. Traditional investors get their capital protection as they have specific ELN notes with principal protection. The notes come to you on a lower-risk scale.
For the more dynamic investors, you have the regular version of ELNs wherein the upscale potential to higher returns is linked to the performance of the underlying assets and this is done by adding a leverage factor into the notes making this investment strategy a slightly complex one.
Different Types of Valuation Methods That Are Adopted For ELNs
As elns are hybrid instruments comprising debt and equity, you can find different equity-linked note valuation methods too. We will now have a comprehensive look at what the different methods are:
- 1. Black Scholes Method
The Black-Scholes method is one of the most commonly used methods of valuation concerning ELNs. Product issuers embed options to the asset-linked portion of ELNs. This is a type of valuation method that uses components like:
- Prices of stocks
- Strike prices (Initial prices or the benchmark above which the final points of underliers move)
- Term of the asset or maturity period
- Interest rates and so on
2. Monte-Carlo Simulation
In this method, product issuers create simulation scenarios that can be adapted to how the working mechanism of ELNs operates. The simulations are mainly used to determine the expected payoff for elns over their time of maturity. In other words, the product issuers draw up simulation curves to determine the expected payoffs for ELNs. This particular method is particularly used by issuing firms if there are complex structures to the notes and if close-ended solutions are not available to determine payoffs on the investment.
3. Binomial or Trinomial Trees
In this method, you create a discrete-time model and the price movements of underlying assets of ELNs are evaluated by adopting a backward induction process. The prices or the final sale point values of underlying movements are therefore gauged by time-based pricing models. This method precisely computes the prices of underlying assets for equity-linked notes.
4. Finite Difference Methods
Here, you adopt numerical styles of determining the expected payoffs of elns. The wealth managers or financial evaluators come up with differential equations that are made to move across price movements of underlying assets the elns are linked to. Statistical charts are predominantly used here to determine ratios of equations vis-a-vis the price movements of ELN underliers. This method is particularly useful if the notes have complex payment structures and it is not possible to deduce the final sale points of assets using analytical methods alone.
5. Risk-Neutral Evaluation
In this method of payoff computation, the ELNs go through a discounted payment method that is charged to investors while the notes are predominantly designed. The elns then give the current value price of elns to investors at the time of redemption. The difference between purchase points and final points of the asset marks the yield of the investment. This is a method for traditional investors who aim to receive an optimal gain on their portfolios while wanting to get their principal investment back.
6. Discounted Cash-Flow Or DCF Analysis
For some of the elns, you have fixed interest components and these notes are also 100 percent principal guaranteed. In this case, the product valuers apply the traditional DCF analysis method to deduce the values of the debt component the elns have. And then, using the same DCF analysis method, the equity-linked assets also get evaluated. This way, you get a fair price value for investors when they want to redeem their investment portfolios.
7. Comparison Method
In the comparison method of evaluation, several products in the market are compared against similar value features of ELNs The pricing dynamics of ELNs arrive at a comprehensive form of comparative analysis of similar value investment products. Therefore, you get a relative valuation against comparing market prices of similar instruments.
8. Hybrid Or Combination Approaches
When you adopt a blend of pricing techniques to arrive at payoff and investment structures, we call it a hybrid method or combination approach of valuation for equity-linked notes. This method is particularly used when the elns have non-traditional payoffs or other complex structures to the working mechanism of the same.
What Are The Different Types of ELNs- Insights Explained
There are three types of ELNs that you can choose from. These are:
- Principal protected ELNs
- Non-principal protected ELNs and
- Hybrid ELNs
Helping you get a run-down into each of the above:
- 1. Principal Protected ELNs
As the name suggests, these are ELNs that come to you with full principal protection. The investors are assured of receiving their principal money at the term of maturity. And, they are assured of receiving their capital amount despite adverse market conditions. The principal protection aspect makes elns appealing to risk-averse investors. Investors will get income through coupon payments or via dividend disbursements while receiving exposure to the equity markets too.
- 2. Non-principal protected ELNs
Non-principal protected ELNs do not guarantee the protection of investor’s capital. If market conditions are favorable, then investors get potential returns of capital from the assets the ELNs are linked to. On the other hand, if market conditions fail or remain adverse, then investors might lose a portion of or the entire value of their capital investment.
Say for instance, if the equity assets of the elns are endowed with call or put options and the market performance behaves otherwise, then investors may lose their capital investment. However, these notes expose investors to higher rates of return as the equity assets are exposed to favorable market conditions.
- 3. Hybrid ELNs
Hybrid ELNs have a mix of principal and non-principal protected ELNs. While the potential returns of these ELNs are linked to the equity assets the notes are linked with, adverse market conditions might allow the value of these notes to depreciate in their index values before they are up for redemption. As ELNs are flexible as structured notes, these notes are so highly in demand amongst investors on the whole.
Key Takeaways
Equity-linked notes provide flexible forms of returns to investors who require more dynamic options for investing. The equity-linked notes provide equity options for investors who want increased dividends or earnings on a lucrative note. At the same time, the prevalence of a debt instrument takes care of an investor’s risk tolerance in a reliable manner.
Therefore, ELN is a type of structured note that can be a prudent investment decision indeed. The investors earn higher returns when the linked-in assets perform well in the market. At the same time, if the markets do not perform well, then investors may lose a portion of their capital investment amount too. The notes also carry credit risks within the whim.
Therefore, investing in ELNS must be done once every investor reads through the terms and conditions before the investor would want to invest by locking in a specific maturity date.
