Embedded Option

What is an 'Embedded Option'

An embedded option is a provision in a security that is an inseparable part of the other instrument. An embedded option is a special condition attached to a security, and in particular, a bond that gives the holder or the issuer the right to perform a specified action at some point in the future. An embedded option is part of another security, and as such does not trade by itself. Nevertheless, it can affect the value of the security of which it is a component. A security is not limited to one embedded option, as there may be several embedded options in one security.

BREAKING DOWN 'Embedded Option'

A call provision, for example, is an embedded option in a bond that would give the issuer the right (but not the obligation) to redeem the bond before its scheduled maturity. In a convertible bond, however, an embedded option may give the holder the right to exchange the bond for shares in the underlying common stock. The presence of embedded options affects the value of the security, and investors should be aware of any embedded options and the potential outcome or impact. For example, a bond that has an embedded option, giving the issuer the right to call the issue, could be less valuable to an investor than a noncallable bond. This is because the investor could lose out on interest payments to which he would otherwise be entitled if the bond were held to maturity (assuming the issuer does call the issue).

RELATED TERMS
  1. Debt Exchangeable for Common Stock ...

    A debt instrument that provides the holder with coupon payments ...
  2. Dividend Enhanced Convertible Stock ...

    Preferred stock that provides the holder with premium dividends ...
  3. Mezzanine Debt

    When a hybrid debt issue is subordinated to another debt issue ...
  4. Reverse Convertible Bond - RCB

    A bond that can be converted to cash, debt or equity at the discretion ...
  5. Expansion Option

    An embedded option that allows the firm which purchased the real ...
  6. Call Privilege

    The provision in a bond indenture that gives the bond issuer ...
Related Articles
  1. Managing Wealth

    Guide To Embedded Options In Bonds

    Investors should be aware of embedded options that may be available in certain securities as these options may affect the value of the security.
  2. Markets

    What's the Option-Adjusted Spread?

    The option-adjusted spread, or OAS, measures a fixed-income security rate’s spread and the risk-free rate of return that’s adjusted to account for an embedded option.
  3. Trading

    Options Pricing: Introduction

    Options are derivative contracts that give the holder the right, but not the obligation, to buy or sell the underlying instrument at a specified price on or before a specified future date. Although ...
  4. Trading

    Options Pricing: A Review Of Basic Terms

    The following is intended as a review of basic option terminology, which can be used as a reference as needed: American Options - An option that can be at any point during the life of the contract. ...
  5. Managing Wealth

    How To Evaluate Bond Performance

    Learn about how investors should evaluate bond performance. See how the maturity of a bond can impact its exposure to interest rate risk.
  6. Investing

    Exploring The World Of Exotic Options

    Exotic options provide investors with new alternatives to manage their portfolio risks and speculate on various market opportunities. The pricing for such instruments is considerably complex, ...
  7. Trading

    Introduction - Day Trading and Options

    Options have not been a tradition part of day-trading strategy, but this is quickly changing.
  8. Managing Wealth

    A Guide to High Yield Corporate Bonds

    The universe of corporate high yield bonds encompasses multiple different types and structures.
  9. Trading

    Options Basics: What Are Options?

    An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock ...
  10. Investing

    Types of Options

    There are many different types of options. In addition to general put options and call option, we will discuss 13 different types of options. Some of these option types are better suited to day ...
RELATED FAQS
  1. What is the difference between an option-adjusted spread and a Z-spread in reference ...

    Learn about the difference between the Z-spread and option-adjusted spread valuations of future cash flows for bonds, and ... Read Answer >>
  2. What is the difference between convertible and reverse convertible bonds?

    The difference between a regular convertible bond and a reverse convertible bond is the options attached to the bond. While ... Read Answer >>
  3. How is convertible bond valuation different than traditional bond valuation?

    Read about bond valuation, particularly the differences between how a traditional bond is valued and how a convertible bond ... Read Answer >>
  4. What risk factors should investors consider before purchasing a callable bond?

    Understand the difference between callable and non-callable bonds and consider all the various risk factors associated with ... Read Answer >>
  5. Under what circumstances might an issuer redeem a callable bond?

    Understand why an interest rate drop usually compels bond issuers to redeem callable bonds and re-issue them at the new, ... Read Answer >>
  6. Which factors most influence fixed income securities?

    Learn about the main factors that impact the price of fixed income securities, and understand the various types of risk associated ... Read Answer >>
Hot Definitions
  1. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
  2. Brexit

    The Brexit, an abbreviation of "British exit" that mirrors the term Grexit, refers to the possibility of Britain's withdrawal ...
  3. Underweight

    1. A situation where a portfolio does not hold a sufficient amount of a particular security when compared to the security's ...
  4. Russell 3000 Index

    A market capitalization weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of ...
  5. Enterprise Value (EV)

    A measure of a company's value, often used as an alternative to straightforward market capitalization. Enterprise value is ...
  6. Security

    A financial instrument that represents an ownership position in a publicly-traded corporation (stock), a creditor relationship ...
Trading Center