Proceeds from the sale of asset-linked notes are typically used by the issuer for general corporate funding purposes and hedging their risk exposure to market price fluctuations under the notes. The principal amount is repaid by the issuer to investors at maturity. The debt portion of index- and asset-linked notes is the economic equivalent of a zero-coupon bond, and the equity component is the economic equivalent of a long-term option. Many investors are confused by the construction of such instruments when they hear of the inclusion of a zero-coupon bond and an option. The words "economic equivalent" are therefore used to convey the fact that no specific zero-coupon bonds and options are taken out of the marketplace to build such instruments. Since asset-linked notes are created around specific market opportunities, their components are tailor-made to the instrument itself; they are created contractually or "synthetically."
Index- and other asset-linked notes are designed to be the economic equivalent of a zero-coupon bond tied to the price movements of an underlying asset, usually represented by either a put or call option. Both the zero-coupon bond and the related option are interwoven into the note. The offering proceeds from such instruments that are not apportioned to the zero-coupon debt component are used to finance the creation of an option relating to the underlying "linked" asset. The option is then designed and embedded into the note to provide an enhanced payout potential to the investor at maturity. The potential value of underlying asset price movements is captured by the investor through the option. The portion of the proceeds not treated as a zero-coupon bond is used by the issuer during the life of the note to hedge its exposure to potential payment obligations to investors arising from future price movements of the underlying asset or index. Such hedging activities involve the purchase of stock options, index options, futures, options on futures, cash securities, over-the-counter contracts, or a variety of the foregoing.
Index- and asset-linked notes allow investors to speculate in worldwide markets while preserving their principal investments, subject to the creditworthiness of the issuer and obligor of the note. An investor receives enhanced interest income from the notes while sharing in the risk and possible reward of stock or other asset price fluctuations. They are issued in the United States by corporations or governmental agencies as Securities and Exchange Commission (SEC) registered and exchange-listed instruments or in private transactions. Also, under certain circumstances, notes on foreign issues can be designed to be currency neutral, that is, hedged against exchange rate movements.
The value of an index-linked note at maturity that is returned to the investor is often determined as principal return plus the final coupon payment, if the notes carry any coupon obligation, plus the contingent payment based on the appreciation, if any, of the underlying asset to which the note is linked (e.g., the principal amount multiplied by the index participation rate).
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