ELNs offer investors enhanced fixed-income yield and equity market exposure. The funds derived from ELN offerings are used by the issuer to structure an instrument that provides investors with the economic equivalent of an enhanced quarterly coupon or dividend yield along with the right, during the life of the note, to participate in a portion of the price appreciation of the stock upon which the ELN is based. ELNs are issued as Securities and Exchange Commission (SEC) registered, exchange-listed instruments or as custom-made products in private transactions. They are typically issued by brokerdealers or by corporations with significant equity stakes in other companies that they seek to "monetize." Corporations often seek to monetize common stock investments in other companies by issuing ELNs and deferring tax on the sale of such holdings.
Chapters 68 examined the linkage of debt securities to the performance of other types of assets, such as equities. Just as options offer flexibility in designing instruments to suit investor's needs, bonds, too, can provide the basis for creating innovative new financial products. Bonds provide a foundation from which traditional payoff patterns in the form of coupon payments can be modified to provide exposure to different types of assets around the world without undue risk to principal. Index- and other asset-linked notes, convertible securities, and equity-linked notes make intuitive sense; they are like having your cake and eating it too. Through a single instrument, an investor can receive the return of his or her principal investment after a stated period of time and, simultaneously, satisfy any speculative inclinations he or she may possess by obtaining market exposure to higher risk asset categories, like stock, currencies, or commodities.
Index- and other asset-linked notes, convertible securities, and equity-linked notes, however, do not usually appeal to natural stock or bond buyers. Bond buyers usually want yield, stock buyers usually want appreciation, and finding buyers that want both requires careful marketing. Many times account executives would rather spend the few moments they have with their clients talking about products that sell themselves and have easier stories to tell, such as the latest initial public offering of a technology stock or corporate bond offering with an attractive yield. Most index- and other asset-linked notes, however, perform well, with yields that often outstrip those of similarly rated bonds, without the downside price risk associated with investments in equities, currency exchange rates, or commodities.
Specific market conditions often make structured notes (as this class of instruments is generally referred to by financial engineers) very attractive, such as during those periods of time in the advanced stages of a bull market where investors want to continue participating in the appreciation potential of stocks but fear a market correction that could wipe out their gains. Structured notes offer an attractive alternative during such periods of time. An investor can move some of his or her market gains into structured notes that provide for continued participation in a more speculative asset class. If the linked asset continues to move up over the life of the note, the investor still participates in such appreciation. But if the linked asset suffers adverse price moves, the investor's principal investment is protected by the creditworthiness of the issuer, just as for all bonds. Over time, as their performance and trading characteristics are studied by investors, it appears likely that index- and other asset-linked notes will move more into the mainstream of investment alternatives.
The next chapter moves back into the option and warrant arena with the introduction of exotic instruments. Exotics are used primarily by market professionals because they can be used to achieve very specific financial goals. The discussion provides an entertaining glimpse at some of the products and investment strategies that are often relegated to the realm of "rocket science." It is like traveling to a new country and tasting the local foods. At first strange, they are soon found to be appealing. Exotic options and warrants are no more complicated than the various types of structured products discussed previously; they just target more specific investment goals. Exotics can still be broken down into their basic component parts and valued and priced in the same ways that stocks, bonds, and standardized options are studied for their investment characteristics.
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