What is an Embedded Option? Types of Embedded Options

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Embedded Option

An embedded option is a type of provision in financial security that gives the issuer or the holder of the security a specific right but not an obligation to perform some select actions in the future. The embedded options cannot be separated from the security, as they exist only as a component of the latter. Embedded options can be fixed to any financial security, but they are mostly attached to bonds.

The point to note is that, one security may have multiple embedded options. The only restriction in such cases is that the options should not be mutually exclusive. For example, a bond cannot contain both call and put embedded options, as the two options are mutually exclusive.

Types of Embedded Options

Embedded options can be broadly divided into two big categories −

  • one is those that provide rights to the issuers, and

  • the other is those that provide rights to the holders of financial security.

Options that offer rights to the issuers of financial security contain the following provisions −

  • Capped floating rate provision− A bond with a capped floating rate provision provides the maximum interest rate an issuer will have to pay to the investors.

  • Call provision− The provision offered to an issuer of a bond has the right to redeem a given bond prior to its maturity date. These callable bonds usually have better coupon rates to compensate the investors for the given potential risk of the early buyback nature of the bond.

Options that offer rights to the holders of financial security come with the following provisions −

  • Put provision − The holder of such a bond has the right to demand pre-payment of the bond’s given principal amount. The embedded put option can be exercised on select predetermined dates. Unlike callable bonds, puttable bonds have lesser coupon rates to compensate the bonds’ issuers.

  • Convertible provision − The holder of a convertible bond has the right to convert the bond to common shares at a predefined rate at a given point in the future. Convertible provision is often attached to preferred shares.

  • Exchangeable provision − The holder of such security (typically a bond and/or preferred stock) gets the right to convert the security into common shares at a predetermined rate at some point in the future.

  • Extendable provision − The holder of such a bond gets the right to extend the maturity date of the bond. Such embedded options are rarely used, and their primary application lies in taking the advantage of long periods of reducing interest rates.

  • Floored floating rate provision − A bond with a floored floating rate offers interest and has the provision that specifies the minimum interest rate the investors will receive from the issuer.

raja
Published on 24-Dec-2021 10:34:24
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