What are embedded options?

Stated simply, embedded options are structured into a particular financial security, thereby allowing one of the parties to execute a specific action, subject to certain terms and conditions.

Factors like financial objectives, risk tolerance, investment horizons and liquidity needs vary across investors. An embedded option, in this case, provides a suite of solutions in keeping with varying investor needs. Though inseparable from the issue, embedded options can be added to or subtracted from the core value of securities, much like the OTC or traded options.

Embedded options in bonds

Embedded options commonly feature in bonds, considering the size of the bond market and unique issuer and investor needs. Some of the more common types of embedded options in bonds include:

  • Callable (redeemable) bonds
  • This is a type of bond that allows its issuer to retain the right to redeem the bond at a particular time, prior to its maturity date. For instance, the issuer would want to call back bonds when prevailing interest rates drop below the rate of interest applicable on the bond.

    This way, the issuer would be able to save money by paying off the debt in full and subsequently issuing bonds at a lower rate of interest.

  • Puttable bonds
  • These come with an embedded put option. It implies that the bondholder, in this case, retains the right (but not the obligation) to ask the issuer for a premature repayment of the principal. The embedded put option can be exercised on one or multiple future dates.

  • Convertible bond
  • Also referred to as a convertible debt or convertible note, these can be converted into a specific number of shares (of a company’s common stock) or cash of equivalent value. This embedded option benefits the bondholder, considering the value of the bond might rise with an increase in the price of the underlying stock.
Alternatively, price of the bond can dip should there be a fall in the underlying stocks’ performance.

In conclusion The key to understanding embedded options in bonds is that they are built into the security, and cannot be separated from the underlying. This is unlike derivatives that closely track performance of the underlying security.

Calls and puts are the more commonly used embedded options, allowing the issuer of the bond and its holder to take opposing bets. The price of entry into either position is the primary differentiator between a vanilla bond and one with an embedded option.

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DISCLAIMER

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.



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