Introduction
Today investing has become more of a necessity than that of a luxury. This is because the inflation rate across countries is increasing at an alarming pace indeed.
To keep up with the pace of inflation, you may have to invest your money into reliable resources to get returns on investment as your regular source of earnings and capitalize on principal redemption that gets disbursed at the end of every investment term.
An active 9-5 job may fetch you an income base to satisfy your dispensable or immediate needs while a passive source of income is necessary to enhance the long-term growth and stability of your lifestyle.
In this parlance, let us touch down on what equity-linked notes risks are. Shall we get started on the same?
Equity-Linked Notes- Meaning And Conceptualization Explained
Equity-linked notes or ELNs belong to the class of structured notes wherein the notes are linked to equity-based assets.
While the notes may offer capital protection at the time of redemption of the notes, the upscale returns on income are linked to the performance of the underlying stocks or security options the notes are linked with.
Investors can earn dividend earnings or improve their cash holdings even if the stocks have a stable or mildly bullish overview in the market.
Therefore, ELNs can be deemed as growth notes too. The overall growth in the value of underlying stocks or equity-based assets helps you achieve your financial goals or wealth-generation objectives on the whole.
What Are Equity-Linked Notes Risks?
These are the following risk factors that are connected with equity linked notes. Let us find out what they are:
- 1. Market Risks
As you are aware, the equity market is subject to the volatility of market conditions. Here, the prices of stocks and shares may rise or fall.
Therefore, ELN which is a debt instrument that is tied to the performance of underlying equities also are subject to a whole fleet of market risks the equity components are exposed to.
- 2. Credit Risk
Credit risk refers to the risk an investor may face if the product issuing company fails to honor payment of coupons or principal repayment. This risk applies even to ELNs.
Sometimes, when you purchase notes from non-investment grade companies that do not have a triple-A rating, this is more likely to happen.
Therefore, as an investor, you must carefully gauge the credibility of the product issuer before you invest with them.
- 3. Economic Risks
In the event of an economic downturn say like a global recession or outbreak of wars, the stocks and shares of different companies may plummet badly. And, this can have a considerable bearing on the return of capital and interest earnings for investors.
You must diversify your investment portfolio into different investing platforms so that even if one portfolio faces losses the other one would pick up.
- 4. Liquidity Risks
At a time when you are faced with financial emergencies or exigencies, it is not that easy to sell ELNs in the secondary market.
Interest-rate fluctuations, differences in price valuations of underlying assets, equity index variations, and other developments affecting equity-linked notes provide liquidity risks on the initial investment amount.
At the same time, ELNs have complex structures that make the liquidity position a tightrope walk for investors on the whole.
- 5. Currency Risks
As ELN is a structured product, the notes can also be linked to currency values as underliers. In this case, the currency can also face fluctuations due to economic downturns or other contingencies that impact the economy as such. Therefore, currency fluctuations also impact the returns on investment for ELNs.
- 6. Capital Erosion Risks
As ELNs are directly linked to the performance of underlying assets, these assets are subject to the volatility of stock markets. The market may have a bullish or a bearish overview. Therefore, there is an underlying risk of 100% capital loss if the price of underlying shares turns zero or even goes negative.
You can look for elns that provide principal protection. These notes are called principal protected elns.
What Are The Valuation Methods Of ELNs?
There are two methods involved when it comes to the valuation of ELNs. These are
1. Discounted Cash Flow Method and
2. Black Scholes Option pricing method
Let us have a look at how each valuation method works:
- 1. Discounted Cash Flow Method
The present value of the ELNs is estimated and then a discount percentage gets added to the purchase price of ELNs. Investors are allowed to buy them at discounted prices while they get the actual value of ELNs at the time of redemption.
The difference between the discounted purchase price and what investors receive upon redemption of ELNs makes up for the yield of the investment.
This option is known as the Discounted Cash Flow method of valuation for ELNs.
- 2. Black Scholes Option Pricing Method
Under the Black Scholes method of pricing, the product-issuing firms estimate the embedded or underlying value of assets or stocks that are linked to these ELNs. The fixed income component also gets evaluated here.
By combining the overall values of the fixed-income component and the equity-linked component, the investors can gauge the overall prices of ELNs.
What Are The Factors Affecting The Prices Of ELNs?
There can be several factors that impact the final value prices of ELNs. As an investor, you must be aware of these factors as they can have a potential bearing on the investment you get upon redemption of the same.
Let us have a run-down into factors that affect the final value prices of ELNs:
- 1. Interest Rate
Changes in interest rates or what is commonly known as interest-rate fluctuations can have a bearing on the overall investment value of ELNs. This is because interest-rate fluctuations can alter the fixed component of the ELNs.
And, the cost of embedded options in the ELNs also goes higher up when the interest rates go up. This way, the equity-index ratios change rapidly to impact the prices of underlying equity of elns.
Therefore, interest rate changes can have an overall impact on the actual value of the investment.
- 2. Volatility Of Market Conditions
The volatility in market conditions can impact the value of stocks and shares in stock exchanges and other financial consoles. Some of the stocks can rise or plummet with bearish markets while a few others show fluctuations in prices on a bullish overview.
When the underlying assets of ELNs mainly comprise equity components, the dynamic pricing of underlying assets can have a visible impact on the final value of the investment that is made available to investors at the time of redemption.
- 3. Returns On Investment
The payoffs in the form of interest income, coupon payments, or dividend earnings also depend on the performance of underlying assets the ELNs are linked to. The yield of investment or returns on investment reveals the solidarity of your investment portfolio. Therefore, the RoI plays a vital role in deciding in favor of ELNs.
- 4. Term Of The Investment
Investors prefer short-term or medium-term investment plans to meet their immediate financial goals.
As structured notes are flexible and can be customized according to your independent requirements, the term or the maturity period of the eln also plays a major role in whether you may want to zero in on the same or not. The same rule holds good in the case of ELNs too.
5. The Level Of Risk-Return Profile
Investors can handle a risk profile by the level of risk tolerance they can take under their belt. While elns offer investors the principal amount with potential returns that are linked to dynamic derivative markets, this option suits dynamic investors and is not that appealing to risk-averse investors.
However, when the final payout comprising full principal protection with a potential upside from securities is for investors who want to grow their wealth baskets on a phenomenal note.
Therefore, when the investors carry a reasonable risk tolerance under their belt with elns, they get far better yields as compared to bonds or fixed-income securities.
The Bottom Line
ELNs are suitable for investors who expect attractive yields from the equity market while trying to protect their capital investment. You may get payoffs in the form of interest payouts, coupons, and dividend earnings from the performance of underlying equity.
ELNs also carry a significant number of risks as in the case of any other form of investment. Therefore, you must read the offer documents carefully before investing.
What are your thoughts on this? Do let us know in the comments!
