Equity Linked Notes
Equity linked notes are securities that offer exposure to the equity market while at the same time guaranteeing a return of principal at maturity. To invest wisely in the notes, you need to know the rewards, risks associated with the notes, and the specific features of the different types of notes.
The equity linked notes are divided into option based notes and non-option based notes.
Option Based Notes
The averaging formula relies on the average of some periodic returns of the security. The returns may be averaged for a specific period of the note’s lifetime or throughout its life.
The average returns are then added together and used to calculate the variable interest at maturity.
The method is considered better than relying on one value to determine the maturity value.
Fixed participation examines the participation rate of the note. The rate is dependent on the cost incurred to structure the note.
In most cases, the participation rate ranges between 60% and 100 %. So long as the final value is higher than the initial value, the note will generate interest.
Unfortunately, this method poses a risk as a single maturity value is used to calculate variable interest.
Equity linked notes that use the optimizing structure are made up of mutual funds, indices and a basket of equities.
The basket that performs the best at the end of the year is locked in. As a result, it is removed from the market. The equity no longer affects the basket either positively or negatively.
At maturity, the best performance from each year is averaged to calculate the interest rate.
The structure focuses on the upside potential of the equity linked note. It limits the extent to which the note can gain.
However, the structure does not put a limit on the downside of the note. If the security dropped, then the periodic cap would prevent the note from recovering from the depressed level.
The Periodic cap is, therefore, suitable for stable securities.
The structure borrows its concept from the periodic cap and the averaging formula. The yield generation Note comes with a guaranteed coupon rate for the first year.
After the first year, interest is paid depending on the performance of the equity. Upward movement of the interest is subjected to a periodic cap, but a downside movement does not have a cap.
There is a condition for you to earn the coupon rate; the stock in your basket must gain by the same percentage as the coupon rate. In most cases, apart from the coupon interest paid in the first year, you are not likely to earn any more interest until maturity.
Non Option-Based Structure
It works differently from an option-based structure, but they have the same objective: they guarantee payment of the principal amount at maturity. The structure does not require you to buy a strip bond at the beginning, and it does not provide any options. A hedge fund or an equity index is used as the security. All the funds available at the beginning are allocated in the securities.
The terms laid down at the beginning determine how the funds to treat regarding allocating it between the fixed income portfolio and the underlying security. The allocation is defendant on the performance of the security in the market. When the performance is high, most of the funds are allocated to the underlying security. Funds are assigned to the fixed-income portfolio during weak moments.
If the structure allows the use of leverage, funds can be borrowed to be used to ensure that the note gets maximum note potential. Leveraging also ensures that there is enough money for repayment of the principal maturity. If the note performs well enough to secure the repayment of the principal amount at maturity, then no funds are apportioned to the fixed income portfolio.
If the equity linked notes perform badly, then all the resources are assigned to the fixed income portfolio. The security acts as a strip bond. To prevent a situation where the funds are allotted to the fixed income security, some structures impose a minimum exposure. A dynamic hedging strategy is sound when the interest rate is rising or flat and when the performance of the equity market is strong.