What is an 'Embedded Option'

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 an inseparable 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.

BREAKING DOWN 'Embedded Option'

A bare option is one that trades separately from the underlying security. A trader can buy and sell call and put options as a separate security on the market. An embedded option, on the other and, is affixed to the underlying security and cannot be bought or sold independently. The embedded option grants the security holder certain rights to redeem or dispose of the security. These options may be linked to equity, commodity and, most commonly, bonds. A security is not limited to one embedded option, as there may be several embedded options in one security.

A call provision, for example, is an embedded option on 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. Another example of an embedded option is a puttable provision on a bond which gives a bondholder the right to “put” the bond and demand early redemption from the issuer.

The valuation of bonds with embedded options is estimated using option pricing techniques. Depending on the type of option, the option price, as calculated using Black Scholes, is either added to or subtracted from the price of the straight bond (i.e. as if it had no options) and this total is used as the value of the bond. Once the value of the bond is determined, the various yields, such as yield to maturity and running yield, can be calculated for the bond.

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. In general, embedded options can either add to or subtract from the value of a bond, depending on whether the option is a benefit to the bondholder or the issuer. 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 callable bond were held to maturity (assuming the issuer does call the issue).

Any embedded options on a bond is spelled out in a trust indenture, which highlights the terms and conditions that a trustee, bond issuer, and bondholder must adhere to during the life of the bond.

Securities other than bonds that have 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 two types of risk – reinvestment risk and the propensity for limited price appreciation. Reinvestment risk is apparent given that when an investor or issuer is prompted to exercise the embedded option, the party receiving the proceeds from the exercise of the option may not be able to profitably reinvest those proceeds. In addition, embedded options almost always 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.

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