Equity-Linked notes are structured products issued by banks and financial institutions then are sold to institutional and retail investors who want to earn a higher interest rate than an ordinary time deposit. Equity-linked notes are yield-enhancing structured products traded over the counter. The underlying can be stock, a basket of stocks, or an equity index. Typical Equity-Linked notes are principal-protected. Even though structured products first appeared in the early 80’s, they are still considered as relatively new investment vehicle. Academic material, publications and information available to the public is relatively scarce.
The purpose of the thesis is to show the cons of Equity-Linked notes and explain that investors need to fully understand their mechanisms before deciding to buy them as there are many hidden agendas. The typical selling arguments for structured products are the possibility of participating only in the up-side potential of a market, the rather low credit risk, and the possibility of providing the investors with tailor-made characteristics. Structured products permit market participants who favor a particular pattern of payments over time to access such a pattern, as well as hedge particular risks.
Equity-Linked notes are illiquid, difficult to monitor properly, and their purchasers will suffer from disadvantageous tax treatment. Trading volume in Equity-Linked notes is miniscule compared to the stocks or stock indexes to which they are linked. Broker-dealer affiliates of issuers usually maintain a secondary market for Equity-Linked notes, however there is no guarantee that such a secondary market will be maintained for any particular note. The return is limited to the potential yield of the Equity-Linked note. Therefore, investors have downside protection but at the same time their return potential is limited.
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Equity-Linked notes might not be suitable for all the investors. Such investments are suitable for purchase and holding until maturity. As not so many issuing institutions are willing to maintain a secondary market, the market is deemed to be illiquid. Consequently, there is high volatility and lack of transparency of movements in prices. Equity-Linked notes require sophisticated analysis to determine the effective allocation between stocks and bonds. Those investors who buy large quantities will not be able to efficiently supervise and rebalance their portfolio.
Investors should be aware that any dividend payment on the underlying security may affect the price and payback of an Equity-Linked note at the expiry date due to ex-dividend pricing. Locking up cash for such a long time period could have a potential consequences such as missing other investment opportunities. Rarely, two different banks will offer notes with the same underlying and similar conditions at the very same moment. Therefore, there is lack of performance transparency as it may be difficult to establish a benchmark. When structured products are sold in units and are classified as unit trusts, they must disclose the management fees.
However, when not sold in units, the issuer will subtract its fees directly from the fund’s yield. In that case, there is no way to determine the cost the issuer charges. The IRS imputes interest income to Equity-Linked notes even if the note does not pay a coupon. This means that investors might need to pay taxes each year out of other resources. When Equity-Linked notes are structured, specific characteristics that are attractive to investors are often emphasized as in the example of precipice bonds where the potential risks were explained in small print.
Consequently, the product looks more appealing than it really is. Investors should read and understand the small print of the offering document as Equity-linked notes can be high-risk investment products. Prospectuses do not focus sufficiently on the information that consumers require in order to make good investment decision. As financial information leaflets are not compulsory, brochures are clients’ primary supply of information. The quantity of public analysis of structured products is still limited. The written media devote little attention to structured products.
When it comes to digital media there are two major websites, Structuredproducts. com and Retialstructuredproducts. com, which are only available to the subscribers. Investors are taking on the credit risk of the issuer of the note. In the case of a note with credit overlay the investor will be taking on the default risk of other issuers. Interest rates for a given maturity affect the cost of principally protecting the note. As interest rate increases, the cost of principal protection decreases and vice versa. The lower the cost of protection, the more equity exposure is possible.
The main concern about Equity-Linked notes arises from their pricing and valuation techniques. The valuation of Equity-Linked notes and any other type of structured products is unclear as various models can be used and every model has its own assumptions and limits. Many empirical studies have been performed to asses the mis-pricing scale of structured products compared to their theoretical values. Other studies have the same conclusion: “No matter how different and advanced methods issuers use when pricing structured products, perceived mis-pricing is always in favor of the issuing institution”.
As miss-pricing trends are demonstrated among all issuers, investment banks should be required to be more transparent in the way they price structured products. The structured products industry has gone through a major growth followed by tremendous innovation. Academics have been judging Equity-Linked notes as unsuitable for retail investors. New regulations coming into force will have major impact on future sales. However, facts are that today they are one of the fastest growing financial instruments , in terms of both, sales and innovations.
The structured product industry has grown at least 20 to 30 % in volume per year since 2000. People still buy and will continue to buy them as further growth is expected to continue. New transparent rules have to be made, especially when it comes to pricing as in academic literature this is the main problem concerning structured products. Retail investors should purchase products at reasonable fees, which are transparent, and they should hold products with a risk profile that is appropriate for their investment needs.
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