What Is an Embedded Option?

An embedded option is a feature of a financial instrument that lets issuers or holders take specified actions against the other party at some future time. Embedded options are provisions included in some fixed-income securities that allow investors or the issuer to do specific actions, such as call back (redeem) the issue early.


Key Takeaways

  • An embedded option is a component of a security that gives either the issuer or the holder the right to take some specified action at present or in the future.
  • An embedded option is usually 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.
  • Examples of embedded options include callable, putable, and convertible securities.

Understanding Embedded Options

Typically associated with bonds, an embedded option is a function that allows holders or issuers of financial securities to take specified action against one another in the future. Embedded options materially affect 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 Calls & Puts

Callable

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. Callable bonds are a tool used by issuers, especially at times of high prevailing interest rates, where such an agreement allows the issuer to buy back or redeem bonds at some time in the future. In this case, the bondholder has essentially sold a call option to the company that issued the bond, whether they realize it or not.

Putable

A putable provision is an embedded option on a bond that positions holders to demand early redemption from the issuer. In contrast to callable bonds (and also not as common as them), putable bonds provide more control of the outcome for the bondholder. Owners of putable bonds have essentially purchased a put option built into the bond. Just like callable bonds, the bond indenture specifically details the circumstances a bondholder can utilize for the early redemption of the bond or put the bonds back to the issuer.

Putable bond buyers make some concessions in price or yield (the embedded price of the put) to allow them to close out the bond agreements if rates rise and invest or loan their proceeds in higher-yielding agreements. Issuers of putable bonds need to prepare financially for the possible event when investors decide putting the bonds back to the issuer is beneficial. They do this by creating segregated funds set aside for just such an event or issuing offsetting callable bonds (like put/call strategies) where the corresponding transactions can essentially fund themselves.

Convertible

A convertible security is an investment that can be changed from its initial form into another form. The most common types of convertible securities are convertible bonds and convertible preferred shares, which can be converted into common stock. With convertible bonds, an embedded options give bondholders the right to exchange the bond for shares in the underlying common stock. Convertible securities usually have a lower payout than comparable securities that do not have the conversion feature. Investors are willing to accept the lower payout due to the potential profit from sharing in the appreciation of a company's common stock through the conversion feature.

The conversion value is similar to the value of the call option on the common stock. The conversion price, which is the preset price at which the security can be converted into common stock, is usually set at a price higher than the stock's current price. If the conversion price is closer to the market price, then it has a higher call value. The underlying security is valued based on its par value and coupon rate. The two values are added together for a more complete picture of the security's valuation.

Valuing Securities with Embedded Options

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 (YTM) 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 they 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.

The Option-Adjusted Spread (OAS)

The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is then adjusted to take into account an embedded option. Typically, one uses Treasury yields for the risk-free rate. The OAS spread is added to the fixed-income security price to make the risk-free bond price the same as the bond.

The option-adjusted spread thus helps investors compare a fixed-income security’s cash flows to reference rates while also valuing embedded options based on general market volatility. By separately analyzing the security into a bond and the embedded option, analysts can determine whether the investment is worthwhile at a given price. The OAS method is more accurate than simply comparing a bond’s yield to maturity to a benchmark.

Non-Bond Investments

Non-bond investments that feature embedded options include convertible preferred shares and mortgage-backed securities (MBSs). Convertible stocks give investors the option to convert their preferred shares into common stock with the issuing company. MBSs 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.