Embedded Option Definition

Embedded option bonds, Valuation and Analysis of Bonds with Embedded Options

Introduction

In the broadest terms, embedded options are components built into the structure of a financial security that provides the option of one of the parties to exercise some action under certain conditions. Embedded options are more commonly found in bonds and preferred stocksbut can also be found in stocks.

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.

While embedded options are inseparable from their issue, their value can be added or subtracted from the core securities price, just like traded or OTC options. In this case, the bondholder has essentially sold a call option to the company that issued the bond, whether they realize it or not.

While there is no guarantee rates will fall, interest rates historically tend to rise and fall with economic cycles. It can also be seen as a two-sided bet; bond issuers project that rates will fall or remain steady, while investors assume they will rise, stay the same or not fall enough to make it worth the issuer's time to call the bonds and refund at a lower rate.

Learning Outcomes

This a great tool for both parties and does not require a separate option contract. One party will be right, and one wrong; whoever makes the right bet receives more attractive financing terms over long-term embedded option bonds.

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Putable Bonds In contrast to callable bonds and not as commonputable bonds provide more control of the outcome for the bondholder. Owners of putable bonds have essentially purchased a put option embedded option bonds into the bond. Just like callable bonds, the bond indenture specifically details the circumstances a bondholder can utilize for the early redemption of the bond or put the bonds back to the issuer.

Just like the issuer of the callable bonds, putable bond buyers make some concessions in how to register a dealing center or yield the embedded price of the put to allow them to close out the bond agreements if rates rise and invest or loan their proceeds in higher-yielding agreements.

What are embedded options?

Issuers of putable bonds need to prepare financially for the possible event when investors decide putting the bonds back to the issuer is beneficial. There are also bonds that are putable on death, which originated with the U.

The pricing of callable and putable bonds given similar maturities, credit risketc. The value of a putable bond is usually higher than a straight bond as the owner pays a premium for the put feature. A callable bond tends to trade at lower prices higher yields of comparable straight bonds, as investors are not willing to pay full price since the embedded call creates uncertainty of the future cash flow from interest payments.

Of course, these general rules only apply if the company remains solvent. In the event that the company does go bankrupt, convertibles are farther down the chain in claims on company assets behind secured bondholders.

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While the issuer does have embedded brackets limiting bondholders to upside and collection upon bankruptcythere is a sweet spot in the middle range.

For example: 1.

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The investor purchases a bond near par and receives a market competitive coupon rate over a period of time. Like a bond, it pays a specified coupon and is subject to similar interest rates and credit risks as bonds. It also has stock-like features, as its value can fluctuate along with the common stock but is by embedded option bonds means linked to the common stock price, or is as volatile.

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Preferreds come in many varieties, like interest rate speculation, since they have some sensitivity to rates. Embedded options in preferreds come in many varieties; the most common are calls, voting rights, cumulative options where unpaid dividends accrue if not paid, conversion, and exchange options.

They may own a long-term callable bond or own mutual funds with exposure to hundreds of these options. The key to understanding embedded options is that they are built for specific use and are inseparable from their host security, unlike derivatives that track underlying security. Calls and puts are the most commonly used in bonds and allow the issuer and investor to make opposing bets on the direction of interest rates.

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The difference between a plain vanilla bond and one with the embedded option is the price of entry into taking one of those positions. Once you master this basic tool, any embedded option can be understood.

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