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Embedded Options in Bonds

An embedded option is a component of the bond contract and grants the holder or the issuer certain rights to dispose of or redeem a bond. It cannot be separated from the bond and therefore does not trade by itself. A bond with security holder options (which benefit the holders) has additional value and therefore will be priced more compared with the identical bonds that do not have such options. A bond with security issuer options (which benefit the issuer) will be priced less than the other identical option-free bond.

Examples below illustrate some comparable embedded options from these 2 categories:

Security holder Options: Security Issuer Options
Put provision gives the holder the right to sell the bond to the issue at a specified price prior to maturity. A bond with this kind of options is called puttable bond. Call provision gives the issuer the pay off the bond from the holder at a specified price prior to maturity. A bond with this kind of options is called callable bond.
Floors set a minimum on the coupon rate for a floating-rate bond. Caps set a maximum on the coupon rate for a floating-rate bond.

 

Other common types of the embedded options include:

Conversion option allows a bond holder to convert the bond into a fixed number of common shares of issuer. A bond with this kind of option is called convertible bond.
Extendibility option allows a bond holder to extend the bond maturity date by a number of years. A bond with this kind of option is called extendible bond.
Prepayment option allows the bond issuer to prepay the loan balance before maturity.

A bond may have more several options embedded as long as they are not mutually exclusive.