An embedded option allows holders or issuers to take specific actions against another party in the future. Some fixed-income securities include embedded options that permit investors to call back or redeem the issue earlier.
Understanding Embedded Options
An embedded option, often associated with bonds and other financial securities, allows holders or issuers to take specific action against each other in the future. Embedded options have a significant impact on the security's value. The embedded option differs from the bare option, which trades separately from the underlying securities. Traders may purchase and sell call or put options. These options are, in essence, separate securities. Contrary to popular belief, embedded options are always linked to the underlying security. They cannot be sold or bought separately.
Redeeming Securities: Embedded Calls & Puts
Callable
Embedded options allow investors to redeem securities before they mature. A call provision, for example, is an embedded option that allows holders to redeem the bond before its scheduled maturity. Issuers use callable bonds, particularly in times of high-interest rates. This agreement allows them to redeem or buy back bonds later. The bondholder has, in effect, sold a call option to whoever issued the bond.
Putable
A putable provision, an option embedded in a bond, allows holders to request early redemption from the issuer. Putable bonds, which are less common than callable bonds, allow bondholders more control over the outcome. Putable bond owners have purchased a put option in the bond. The bond indenture, similar to callable bonds, details the circumstances that a bondholder can use for early redemption or returning bonds to the issuer.
To close bond agreements, putable bond buyers may make concessions on price or yield (the embedded price of the put) and then borrow or invest their proceeds in higher-yielding contracts. Putable bond issuers must be financially prepared for any eventuality when investors decide to return the bonds to them. This is done by creating separate funds or issuing offset callable bonds (like put/call strategy) that can be used to fund the transactions.
Convertible
Convertible security refers to an investment that can be converted from its original form into another. Convertible preferred shares and convertible bonds are the most popular types of convertible securities. These can then be converted into common stock. Convertible bonds have an embedded option that allows bondholders to convert the bond into common stock.
Convertible securities often pay a lower dividend than similar securities that do not have the conversion feature. Due to the possibility of profit sharing in the company's stock appreciation through the conversion feature, investors are willing to accept a lower payout.
The conversion value is the same as the value of the common stock call option. The stock's current stock price is used to determine the conversion price. This is the price at which common stock can be converted from security. A conversion price close to the current market price will give it a higher call price. The par value and coupon rates are used to determine the value of the underlying security. These two values are combined to picture the security’s value better.
Valuing Securities with Embedded Option
Option pricing techniques are used to determine the value of embedded options bonds. Depending on your option type, the option price can be added or subtracted from the straight bond price. Once the bond's value has been determined, different yield values, such as the running yield, and yield to maturity, can be calculated.
Investors should be aware that embedded options can increase or decrease a security's value. An embedded option, for example, gives the issuer the right to call the issue. This could make the bond less valuable than a non-callable bond. The investor might lose interest payments if the callable bond is held to maturity. The trust indenture outlines the terms and conditions that bond issuers, trustees, and bondholders must adhere to.
Option-Adjusted Spreads
OAS measures spread between fixed income security rates and the risk-free rates of return. This is then adjusted to include an embedded option. For the risk-free rate, it is common to use Treasury yields. To make the bond's risk-free price equal to the OAS spread, fixed-income security prices are added.
Investors can use the option-adjusted spread to compare fixed-income securities' cash flows to reference rates. It also helps them value embedded options that are based on market volatility. Analysts can assess whether an investment is worth the price by separately analyzing the embedded option and the security as a bond. Using OAS rather than merely comparing the yield to maturity of a bond to a benchmark provides a more accurate assessment.
