Embedded Options
Options are financial instruments called derivatives which are based on the value of underlying securities known as stocks. An options contract offers the buyer the opportunity to buy/sell—depending on the type of contract they hold their underlying asset. Unlike futures, the holder is not required to buy/sell the asset if they choose not to. Call options allow the holder to buy the asset at an announced price within a specific timeline. Put options allow the holder to sell the asset at an announced price within a specific timeline. Each option contract has a specific expiration date by which the holder exercises their option. The announced price on an option is known as the strike price. Options are normally bought and sold through online or retail brokers.
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What are Embedded Options?
An embedded option is a financial security that provides the issuer/holder the right to take certain actions in the future. An embedded option is an inseparable part of another security that cannot exist as a discrete entity. The involvement of an embedded option can materially impact the value of that financial security. Embedded options make investors at risk to reinvestment risk and show them the chance of limited price appreciation. An embedded option is a provision in financial security (mainly in bonds) that provides an issuer/ holder a certain right but not an obligation to perform some actions at some point in the future.
How do they work?
The most usual embedded options used by an issuer are as follows:
- The right to call the issue
- Including an accelerated sinking fund provision
- Capping a floating-rate
- Maintaining the right to prepay principal
The most usual embedded options given to investors are as follows:
- The right to put the issue
- Conversion privileges
- Putting a floor on a floating-rate
Let’s assume Company ABC issues bonds with an embedded option that allows the bondholders to convert their bonds into shares of stock (known as a convertible bond). The bondholder has the right to convert bonds into shares of Company ABC stock in a conversion ratio of $2000 par value per X amount of shares. The specific conversion rate is found in the bond’s indenture agreement. Embedded options are found in a variety of securities. For e.g: convertible preferred stocks come with the embedded option to convert the shares into common stock. Mortgage-backed securities (MBS) may have embedded prepayment options, and putable bonds have embedded options that permit the holder to make the issuer buy the bond back at par value on /after a certain date.
Types Of Embedded Options:
Embedded options can be divided into two major categories:
Those that provide rights to the issuers of financial security and the ones that provide rights to the holders of financial security. Options that provide rights to the issuers of financial security contain the following provisions:
- Call provision: An issuer of a bond has the right to redeem a bond prior to the maturity date. The callable bonds normally have higher coupon rates.
- 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.
Options that provide rights to the holders of financial security occur with the following provisions:
- Put provision: The holder of a bond has the right to demand early repayment of the bond’s principal amount. The embedded put option is exercisable on predetermined dates.
- Convertible provision: The holder of a bond has the right to convert the bond into common shares at a predetermined rate at some point in the future. They are frequently attached to preferred shares.
- Exchangeable provision: The holder of security (mainly a bond or preferred stock) has the right to convert the security into the common shares of a company other than the issuer at a predetermined rate and at some point in the future.
- Extendable provision: The holder of a bond has the right to extend the maturity date of a bond. This type of embedded option is rarely used.
- Floored floating rate provision: A bond with a floored floating rate provision specifies the minimum interest rate that the investors will receive from the issuer.
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Example:
- The investor purchases a bond near par and receives a market competitive coupon rate over a period of time.
- During that time, the underlying common stock appreciates above the previously set conversion ratio.
- The investor converts the bond into stock trading above the conversion premium, and they get the best of both worlds.
Key Takeaways:
- One security contains multiple embedded options.
- A bond does not come with a call and put embedded options because both options are mutually exclusive.
- Embedded options cannot be split from the securities to which they are attached.
- Embedded options are built for specific use and are inextricable from their host security, unlike derivatives that track underlying security.
- The distinction between a plain vanilla bond with the embedded option is the price of entry by taking one of those positions.
Author- Moksha Gala
About the Author: Currently, a graduate in the field of accountancy and finance. Commerce has been a part of my life now. Exploring the available choices, finance was always distinct among them. Credits, investments, and markets were always a part of my interest. So decided to embrace finance as a career for life.
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