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.
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.
Types of Embedded Options
Embedded options can be divided into two major categories: those that provide rights to the issuers of a financial security and those that provide rights to the holders of a financial security.
Options that provide rights to the issuers of a financial security contain the following provisions:
- Call provision: An issuer of a bond has the right to redeem a bond prior to the maturity date. The callable bonds generally have higher coupon rates to compensate the investors for the potential risk of the early repurchase of a bond.
- Capped floating rate provision: A bond with a capped floating rate provision specifies the maximum interest rate that an issuer will pay to the investors.
Options that deliver rights to the holders of a financial security come with the following provisions:
- Put provision: The holder of a bond has the right to demand early repayment of the bond’s principal amount. The embedded put option is exercisable on predetermined dates. Unlike callable bonds, puttable bonds carry lower coupon rates to compensate the bonds’ issuers.
- Convertible provision: The holder of a bond has the right to convert the bond into common shares at a predetermined rate at some point in the future. Additionally, a convertible provision is frequently attached to preferred shares.
- Exchangeable provision: The holder of a security (typically a bond or preferred stock) has the right to convert the security into the common shares of a company other than the issuer at a predetermined rate and at some point in the future.
- Extendable provision: The holder of a bond has the right to extend the maturity date of a bond. This type of embedded option is rarely used, and its primary application is taking advantage of long periods of declining interest rates.
- Floored floating rate provision: A bond with a floored floating rate provision specifies the minimum interest rate that the investors will receive from the issuer.
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.