What Is an Embedded Option?

An embedded option is a feature of a financial security that lets issuers or holders take specified actions against the other party, at some future time.

Key Takeaways

  • An embedded option is a component of a financial security that gives the issuer or the holder the right to take a specified action in the future.
  • An embedded option is an inseparable part of another security that cannot exist as a stand-alone entity.
  • The inclusion of an embedded option can materially impact the value of that financial security.
  • Embedded options make investors vulnerable to reinvestment risk and expose them to the possibility of limited price appreciation.

Understanding Embedded Options

Typically associated with bonds, an embedded option is a function letting holders or issuers of financial securities take specified action against one another, in the future. Embedded options can materially affect on the value of a security.

Embedded options differ from bare options, which trade separately from their underlying securities. In the latter group, traders may buy and sell call and put options, which are essentially separate securities from the investments themselves. Contrarily, embedded options are inexorably linked to the underlying security. Consequently, they may not be bought or sold independently.

Redeeming Securities

Embedded options give investors the power to prematurely redeem a security. For example, a call provision is a type of embedded option that affords holders the power to redeem the bond before its scheduled maturity. With convertible bonds, embedded options give holders the right to exchange the bond for shares in the underlying common stock.

A putable provision is an embedded option on a bond that positions holders to demand early redemption from the issuer.

The valuation of bonds with embedded options is determined by using option pricing techniques. Depending on the type of option, the option price is either added to or subtracted from the price of the straight bond that has no options attached. After the value of the bond is determined, various yield values such as yield to maturity and the running yield may then be calculated.

Because embedded options may increase or decrease the value of a security, investors should be acutely aware of their presence. For example, a bond that has an embedded option gives the issuer the right to call the issue, potentially rendering the instrument less valuable to an investor than a non-callable bond. This is mainly due to the fact that the investor may lose out on interest payments he or she might otherwise enjoy if the callable bond were held to maturity.

Embedded options on a bond are spelled out in a trust indenture, which delineates the terms and conditions that trustees, bond issuers, and bondholders must all observe.

Banks that heavily invest their earning assets in products with embedded options at the generational low for yields on fixed-income assets are often vulnerable to rising interest rates.

Non-Bond Investments

Non-bond investments that feature embedded options include convertible preferred shares, and mortgage-backed securities (MBS). Convertible stocks give investors the option to convert their preferred shares into common stock with the issuing company. MBS can have embedded prepayment options, which give mortgage holders the option to repay early.

Embedded options expose investors to reinvestment risk, as well as the propensity for limited price appreciation. Reinvestment risk manifests if an investor or issuer exercises the embedded option, where the recipient of the transactional proceeds is forbidden from reinvesting them.

Furthermore, embedded options customarily limit a security's potential price appreciation, because when market circumstances change, the price of the affected security may be capped or bound by a specific conversion rate or call price.