Equity-Linked Note

An Equity-Linked Note (ELN) refers to a structured hybrid financial debt instrument that has a mix of a bond and equity option, providing a return linked with the underlying entity. It offers investors exposure to the profitable side of the equity investment while also giving them a level of protection through fixed-income elements.

They provide coupon rates or fixed interest rates to investors spanning a fixed term of one to ten years. Moreover, the return of ELNs directly depends on the performance of their underlying assets. ELNs are often utilized as a component of diversified portfolio investments to increase returns. However, since security value fluctuates with the market, investors must be careful when investing in ELNs.

• An equity-linked note is a type of structured financial product that combines elements of both bonds and equity options whose return remains tied to the performance of an underlying asset.
• It offers investors some exposure to the potentially profitable side of equity investments while providing a certain level of protection through fixed-income components.
• ELNs have risks similar to those of other financial instruments, including market, credit, and liquidity risks.
• In technical terms, ELNs operate by merging a fixed-income component, often a zero-coupon bond, with an equity option.

An equity-linked note is an investment product combining the features of equity options with fixed-income securities. These notes have two components – principal and interest. ELNs protect the principal amount with a zero-coupon bond, which gets paid out at maturity. As a result, investors are protected from losing their principal investment. Moreover, they get exposure to high returns equity markets.

ELNs do not offer a guaranteed yield to maturity or fixed interest component, but the interest part gets invested in equity options. After the ELNs mature, investors receive the payoff from equity options and original principal investments. These instruments have an investment period of only one to four months, making them short-term investments. They remain held by investors instead of being traded in the secondary market.

Some ELNs offer principal protection to attract risk-averse investors. However, some ELNs deploy leverage, attracting investors who want higher returns. ELNs serve as an alternative investment tool to traditional low-yielding fixed-income securities with high total returns.

Additionally, investors receive the profits generated from investing in equity options, along with the principal invested amount. Understanding the potential equity-linked notes risks will help investors to make informed decisions. Also, grasping the concept of equity-linked notes knock-out returns will help them protect their investments effectively.

Let us use a few examples to understand more about ELNs.

Example #1

Imagine Sean, an investor, buys an ELN that is based on the stock performance of a certain technology company for three years. At maturity, Sean will get a higher return on her investment if the stock price rises throughout this period. However, Sean can receive a smaller payout and even lose the principal if the stock price falls or stays the same. This illustration shows how ELNs provide investors with the chance to profit from the success of specific stocks without taking on related risks.

Example #2

A notable type of ELN is the reverse convertible note. It has the following characteristics:

• It offers a coupon with high-interest payments
• It allows exposure funds to only one security or index
• Investor receives interest periodically
• If the value of the underlying asset of ELNs falls below a fixed level, then the investor gets their shares of the invested underlying security at maturity.

Another prominent example is auto-callable notes, distinguished by the following features:

• If the value of the underlying asset of the ELNs remains above the predetermined level, investors receive a higher interest rate
• If the value falls below this level, the issuer has the right to recall the ELNs
• Investors get an amount far less than the invested principal.

ELNs carry various risks similar to other financial instruments:

• Credit risk: ELN value largely depends on the issuer's creditworthiness. As a result, if the issuer goes bankrupt, investors might lose all their investments.
• Market risk: If the underlying security of ELNs gets affected by market volatility, then it impacts the ELNs’ performance and yield.
• Liquidity risk: ELNs do not have liquidity characteristics. It means investors cannot sell their ELNs before maturity and may find it difficult to sell them to another buyer.
• Complexity risk: ELNs’ terms and associated risks are quite complex. Hence, they become a complex financial asset for investors.
• Counterparty risk: Some dealers or banks may lack market exposure, potentially hindering their ability to fulfill obligations. Hence, ELNs involving a counterparty may be risky for investors.
• Currency risk: Some ELNs have foreign currency as their underlying asset. These ELNs may have the risk of value fluctuation as the foreign exchange rates fluctuate. As a result, the investor may get caught in fluctuating and loss-making ELNs.
• Early redemption risk: Some issuers tend to redeem them before maturity. Hence, the investors may not get the returns promised by the ELNs.

Considering the risks mentioned above, investors must consult professionals to safeguard their investments from going into losses. Additionally, careful examination of the offer document, prospectus, and related terms and conditions is necessary before investing in ELNs. Due to the complexity of equity-linked notes accounting treatment, assessing ELNs' risk can be challenging.

This article has been a guide to what is an Equity-Linked Note (ELN). Here, we explain the concept in detail along with its examples and risks. You may also find some useful articles here -

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