What are stocks with embedded derivative options?

A simple definition of embedded derivatives would be a hybrid security that features a derivative component integrated with a non-derivative security. A few financial instruments stand out from the rest because of them conjoining a derivative and a non-derivative within onecontract. In such a scenario, it is the derivative component that’s referred to as the embedded derivative.Here, we delve deeper into this concept and try explaining it in as simple terms as possible. Read on:

A non-derivative contract, also called the ‘host’ contract, embeds a derivative component as a part of a single financial instrument. This is what is referred to as an embedded derivative.
An embedded derivative warrants that a proportion of the host contract’s cash flows be aligned with modifications in a variable, including commodity price or rate of interest, for that matter.

ABC Ltd. is a publicly listed company that issues bonds. However, the payment of coupon rate as well as the principal sum has been indexed with the price of gold. In such a scenario, these payments are directly correlated with the price of gold that is prevalent in the market.In this case, while the bonds represent the non-derivate part, it is the gold that is the derivative component. It is this that is known as an embedded derivative.

Embedded derivatives can be used with a number of contracts. That being said, it has been used more frequently with insurance contracts, lease arrangements, convertible bonds and preferred stocks .Many organizations use embedded derivatives to manage risks. Case in point, certain companies meet production costs in a particular currency while earn revenues in another. In the process, these organizations make themselves vulnerable to volatilities stemming from currency fluctuations.In a bid to guard themselves against such risks, these companies hedge them with derivative contracts that are available in the market, including occupying positions in options and futures.That being said, currency fluctuation risks can be embedded within the sales contract. In this arrangement, revenues can be aligned with the production costs that are incurred by the company. A classic example of embedded derivatives, this takes away from the volatility of the contract.Embedded derivatives help in constructing complex yet structured financial products. In conclusion Prior to investing, one should understand financial implications of using embedded derivatives, the underlying as well as factors that can impact it.

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.