An embedded option is a component of a financial bond or other security, and usually provides the bondholder or the issuer the right to take some action against the other party. There are several types of options that can be embedded into a bond. Some common types of bonds with embedded options include callable bond, puttable bond, convertible bond, extendible bond, exchangeable bond, and capped floating rate note.

1. Embedded Options
Ali Heidari

2. • Bonds are financial instruments that help governments,
companies or other issuer of the bond to borrow money from the
market.
• Options are financial instruments, which offer the buyer of the
contract a right but not the obligation to buy or sell the underlying
security.
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Bond and Options

3. • An embedded option is a special condition attached to a security
and, in particular, a bond, that gives the holder or the issuer the
right to perform a specified action at some point in the future.
• An embedded option is an inseparable part of another security,
and as such does not trade by itself. Nevertheless, it can affect the
value of the security of which it is a component.
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Embedded Option

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Embedded Option

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• These options may be linked to:
– Bonds (most common)
– equity
– commodity
Embedded Option

6. 6
Company XYZ issues bonds with an embedded option that allows
the bondholders to convert their bonds into shares of stock.
Embedded Option Example

7. Embedded options can be divided into two major categories:
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Types of Embedded Options
provide rights
to the issuers of
a financial security
provide rights
to the holders of
a financial security

8. • Call provision: An issuer of a bond has the right to redeem a bond
prior to the maturity date. The callable bonds generally have
higher coupon rates to compensate the investors for the potential
risk of the early repurchase of a bond.
• Capped floating rate provision: A bond with a capped floating
rate provision specifies the maximum interest rate that an issuer
will pay to the investors.
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issuers

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Callable bond
Allows the issuer of the bond to retain the privilege of redeeming
the bond at some point before the bond reaches its date of
maturity. For example, assume that at the time of issuance of the
bond;
market interest rate: 7%
coupon rate of 8%.
market interest rate 4%
coupon rate of 5%.

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Valuation with Embedded Options
price of callable bond =
price of straight bond – price of call option

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holders
• Put provision
• Convertible provision
• Exchangeable provision
• Extendable provision
• Floored floating rate provision

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Puttable bond
• The holder of the puttable bond has the right, but not the
obligation, to demand early repayment of the principal.
The put option is exercisable on one or more specified dates.
Price of puttable bond =
Price of straight bond + Price of put option