What is an Embedded Option?

An embedded option is a provision attached to bonds in which the bondholder or the issuer of the bon to carry out certain actions against the other party at some time in the future. Diverse kinds of options can be embedded into a bond, for instance an option can state that a bondholder or issuer of the bond can redeem or dispose of the bond at a certain time in the future. An embedded option cannot be separated from the original security or bond. This option is also a right enjoyed by the bondholder or the bond issuer, it is not an obligation.

How Does an Embedded Option Work?

An embedded option is attached to securities such as equities, commodities and bonds. Unlike a bare option that can be traded separately from the underlying security, an embedded option is inseparable from the bond it is attached to. Through the rights granted by the embedded option, a trader can decide to redeem a security or dispose of it. Common examples of embedded options are calls and puts. If the embedded option os a put option, it gives the bondholder the right to redeem a bond prior to its maturity date, if it is however a call option, the bond issuer can redeem the bond before it matures. Another instance of embedded option is the right of a bondholder to exchange a particular bond for other shares. An embedded option can either be to the benefit of the bondholder or to that of the bond issuer. Whichever the case is, the value of a bond is affected by the impact of the embedded options of the bond. For an embedded option that provides a call option, the investor would not derive much value from the bond as a result of cassation of interest payment on the bond. It is important to know that provisions for embedded options in a bond transaction is clearly stated in the trust indenture. The trust indenture rolls out the obligations of the parties involved in the transaction and the rules that must be adhered to. Although, embedded options offer additional benefits to investors and bond issuers on the underlying stock or bond that is traded, there are certain dark sides of embedded options. Reduction in the value of the bond, reinvestment risk and some other risks are associated with embedded options. An investor with this type of bond can be exposed to any of the risks. There are other security instruments that have embedded options, these include convertible stocks or convertible preferred shares and MBS, these are mortgage-backed securities. In the case of convertible stocks, an investor can convert or exchange the stock for a common stock issued by the company.