What Is an Embedded Option?

An embedded option is tructured into a contract associated with a security that allows one party to take a specific action against the other. One example is a callable bond, which allows the issuer to buy back the bond from the holder at any time, or at specified times, depending on the structure of the contract. It is not possible to sell the security separate from the option. Valuing securities with embedded options can be more complex, as the option may increase or decrease the value, depending on what it does, and the condition of the economy.

Bonds, a type of debt instrument used to raise funds for company operations, commonly come with an embedded option. They are not the only form of security that can be attached to such options. In the contract associated with the sale, the nature of the option should be discussed, along with any specific limitations or stipulations. For example, the option may mature on a given date. Before that time, the holder cannot exercise it.

In addition to callable bonds, some companies issue puttable bonds, which are the exact opposite. The holder of a puttable bond can sell it back to the issuer at any time, demanding payment for the face value. Callable bonds benefit issuers, as they can choose to buy back bonds if interest rates drop, allowing them to refinance if necessary. Puttable bonds, on the other hand, benefit the holders, because they can choose to sell a bond if interest rates rise, putting the investment into another bond that will offer better interest.

Convertible bonds, allowing holders to convert their bonds to stock, are another option. A variety of other embedded options are available with different kinds of securities. Some are quite complex, and may only be used in limited settings. It is important to read contracts and terms carefully to understand the embedded option that may accompany a security. With a callable bond, for example, the investor runs the risk of having the issuer buy it back, not making any more interest payments.

To determine the value of an embedded option, analysts can look at the value of the security by itself, and then add the cost of the option. Options are openly traded on the market, which makes it possible to come up with a fair estimate. Analysts may also consider where the advantages lie; a callable bond, for example, may be worth less than the bond alone, because the investor might lose out on interest if the issuer exercises the embedded option.