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).