The Importance of Embedded Options

CFA Level 1 - Fixed Income Investments

Embedded options grant the issuer or bondholder certain rights in order to dispose of or redeem a bond. Because these options carry some sort of value, they can have a dramatic effect on the price of a security's cash flow as well as its total return.

 

Options that Benefit the Issuer.

• Call options - allows the issuer to call the bonds prior to maturity if prevailing rates decrease enough to make it economically feasible for the issuer to replace the existing issue (consisting of higher rate coupons) with lower coupon bonds.
• Prepayments - the benefit of prepayment is the same as a call option, in that it allows a company to end a contract early.
• Caps - Acap puts a lid on the amount that an issuer has to pay in the face of rising interest rates, when their bonds coupon is based on a floating interest rate.

Options that Benefit the Holder

• Puts - This option is the exact opposite of a call. It allows the bondholder to sell the bond or "put" the bond back to the issuer at a certain price and date(s) before its maturity. As rates rise, this helps the bondholders dump their holdings and reinvest their proceeds at a higher rate.
• Floor - As mentioned earlier, a floor enables a firm to set a limit on how low the payment of their coupon can be. This benefits the holder because as rates decrease, it holds their interest payment at a certain level even as market rates decline below the floor level.
• Conversion Privilege - This allows the bondholders to exchange their current bond with equity in the same firm using convertible bonds.   They may also receive equity or fixed income securities in another firm by the use of exchangeable bonds. This benefits the holder because if the equity or other securities of the firm is outperforming the bonds, the bonds can be converted, allowing the holder to realize a higher return.

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