An embedded option is a provision in a financial security (typically in bonds) that provides an issuer or holder of the security a certain right but not an obligation to perform some actions at some point in the future. The embedded options exist only as a component of financial security such as a bond or stock and cannot be separated from it. Although embedded options can be attached to any financial security, they are mostly included in bonds.
One security may contain multiple embedded options. The only restriction in such a case is that the options cannot be mutually exclusive. For instance, a bond cannot come with both call and put embedded options since the two options are mutually exclusive.
Valuation with Embedded Options
The valuation of financial securities with embedded options is definitely a more sophisticated process relative to the valuation of their plain vanilla counterparts. Essentially, the valuation of securities with an embedded option is a combination of the valuation of plain-vanilla bond or stock and options valuation.
For example, the value of a callable bond for the bondholder equals the value of the underlying plain-vanilla bond minus the value of the embedded call option. Thus, the applications of option pricing models (e.g., Black-Scholes model) and short-rate models can be frequently encountered in the valuation of securities with embedded options.
Embedded options may be extremely beneficial to financial markets. Such options generally provide both investors and businesses with a wide degree of flexibility to develop the most appropriate design of financial security to better suit the needs of the involved parties.
On the other hand, the complexity of the securities makes their pricing less predictable, which, in turn, may result in greater risk.
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.
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