What it is:
How it works (Example):
Different from a stand alone option, an embedded option is an option that is embedded into the stock, bond, etc., and there may be more than one embedded option in a security. Embedded options generally cannot be separated from the securities to which they are attached.
Here are descriptions of the most common embedded options used by issuers:
- the right to call the issue
- including an accelerated sinking fund provision
- Capping a floating-rate
- maintaining the right to prepay principal
Description of the most common embedded options granted to investors are:
- the right to put the issue
- conversion privileges
- putting a floor on a floating-rate
Let's assume Company XYZ issues bonds with an embedded option that allows the bondholders to convert their bonds into shares of stock (known as a convertible bond). Bondholder have the right to convert bonds into shares of Company XYZ stock in a conversion ratio of $1000 par value per X amount of shares. The specific conversion rate can be found in the bond's indenture agreement.
Although they are most common in bonds, embedded options can be found in a variety of securities. For example, convertible preferred stocks come with the embedded option to convert the shares into common stock. Mortgage-backed securities (MBS) can have embedded prepayment options, and putable bonds have embedded options allowing the holder to make the issuer buy the bond back at par value on or after certain date
Why it Matters:
It's extremely important for investors to realize the presence of an embedded option in a security affects the value of the security.
For example, a callable bond is worth less to an investor than a noncallable bond because the company issuing the bond has the power to redeem it and deprive the bondholder of the additional interest payments he'd be entitled to if the bond was held to maturity.
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Embedded options generally add two dimensions of risk for investors. First, they introduce reinvestment risk: when market circumstances prompt an investor or issuer to exercise the embedded option, the party receiving the proceeds from the exercise of the option may not be able to profitably reinvest those proceeds.
Second, embedded options almost always limit a security's potential price appreciation because when market circumstances change, the price of the affected security may be capped or bound by a specific conversion rate or call price.