Embedded Option

Embedded Option Meaning

An embedded option refers to a provision within a financial instrument that grants the issuer or the investor the right to take specific actions in the future against the other party. This option is integral to the financial instrument and cannot be traded separately.

It allows the holder of the option to exercise certain rights, such as early redemption, conversion, or other actions, depending on the terms specified in the instrument. The presence of an embedded option can significantly impact the pricing and risk profile of the instrument, and the valuation of embedded options can be complex and vary based on the specific type of option involved.

• An embedded option can be defined as an inherent feature that facilitates the issuer and investor to take specific actions at a future date against the other party.
• The issuer or investor will have certain rights depending on the option type. But applying two or more mutually exclusive options on a bond is impossible.
• The contract terms, bond price, and rights and obligations of both parties are predetermined and communicated before the investor buys the security from the issuer.

Embedded Option Explained

An embedded option in financial instruments, such as bonds, can be defined as an inherent feature that grants the issuer or investor the right to take specific actions at a future date against the other party. This provision is integral to the instrument and cannot be traded separately.

This option influences the pricing of the instrument and its effect on various factors. Valuing embedded options can be a complex process that depends on several factors, including the option type, prevailing interest rates, and market conditions.

The options-adjusted spread (OAS) is one technique that helps determine the effect of options on the bond value and future cash flows. It is done by considering the spread of embedded bond yield and the risk-free rate of return using the Treasury bond.

Generally, the embedded bond's value is considered a combination of the vanilla (plain) bond value and the option value. Some options will increase the net value, while others will decrease the net bond value. However, this does not mean the bond and options are independent entities. The option comes with the bond and cannot be added or removed later.

Options provide various advantages to both the parties – issuers and investors. They give the parties a certain amount of control in the contractual relationship. Nevertheless, it is evident that in such a relationship, when one party benefits, the other is likely to lose. Therefore, to protect the other party, compensations in terms of low or high yield are provided to them.

Further, the terms of the contract and options are communicated while the investor buys from the issuer. The rights and obligations of the issuer and investors are also discussed to ensure clarity and understanding in the future.

Types

The three main types of embedded options are callable, putable, and convertible.

#1 - Callable options

The callable option allows the issuer to recall the bond before its maturity date. Due to the option for early redemption, which will put the investors at a disadvantage, the coupon rates for such bonds are higher. The call provision is helpful at times of higher prevailing interest rates in the market.

#2 - Putable options

The put provision usually benefits the investors by giving them the right to demand early redemption or repayment of the bond's principal amount. The coupon rates for putable options are generally lower to offset the loss issuers might incur.

#3 - Convertible options

This option allows investors to convert their preference shares or bonds to common shares of the issuing company at a predetermined conversion ratio. Investors can expect a lower yield with a convertible bond embedded option. However, the objective is to gain from capital appreciation.

Examples

Study the examples given here to understand the concept better.

Example #1

Consider the example of a convertible bond embedded option. A company issued convertible bonds to its investors when the stock price was $50. The conversion price at which the option can be exercised (but not necessarily) was fixed at $75. The management urged its investors to convert their bonds to common stock so that it could manage its debt better. The company was growing fast, and the investors expected to earn better with the capital gains from the stock and the dividend payments.

Example #2

Here's an example of sustainability-linked bonds (SLBs) that are considered a replacement for green bonds. SLBs have an embedded option that allows issuers to be punished with higher interest rate payments if they cannot adhere to environmental targets such as emissions. SLBs are now considered a development over green bonds, which do not penalize companies.

Nevertheless, despite their popularity among bond investors, the market for SLBs declined by 37% to $60 billion in 2022 over the previous year. The investors have become picky. One reason is that the companies can reduce their borrowing costs due to the 'sustainability' label. Another reason is that the rewards promised to SLB option holders are low.

Risks

As mentioned, it can have certain demerits too. These demerits appear in the form of risks. Let's discuss the most common risks investors face while using this option.

#1 – Reinvestment risk

The reinvestment risk means that the investors won't be able to reinvest their returns into another security due to a lower rate of return. Embedded provisions, especially in callable bonds, are vulnerable to this type of risk, as they are redeemed when interest rates in the market start rising, thus exposing the investor.

#2 – Risk of limited price appreciation

Investors face another risk when their yield is capped. Issuers can limit their returns, preventing them from paying additional returns after a specified value if the company or economy overperforms. Therefore, bondholders will not be able to reap the benefits of appreciation as stockholders.

#3 – Interest rate risk

Finally, the risk from interest rate fluctuations in the market is characteristic of all bonds. It can decrease the market value of bonds and reduce the investors' yield. Further, the issuers are only financially protected if the investor exercises the putable option in such a situation.

The diagram below explains how the embedded option affects interest rate risk. While measuring interest rate risk, the cash flow should be stable. But sometimes borrowers make advance repayments, or investors withdraw funds, etc, all due to interest rate fluctuations. This affects the stability of cash flow. This, in turn, affects the duration and the convexity of assets and liabilities, increasing the risk. Sometimes banks ignore this fact, and as a result, there are huge errors, and this leads to losses for banks. This fact is explained in the graph below.

Source

Frequently Asked Questions (FAQs)

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