An embedded option is a provision in a bond indenture that gives the issuer and/or the bondholder an option to take some action against the other party. These options are embedded because they are an integral part of the bond structure. In contrast, "bare options" trade separately from any underlying security.

Embedded options may benefit either the issuer or the bondholder. An embedded option benefits the issuer if it gives the issuer a right or it puts an upper limit on the issuer's obligations. An embedded option benefits the bondholder if it gives the bondholder a right or it puts a lower limit on the bondholder's benefits.

Callable Bonds

A bond issue that permits the issuer to call or refund an issue prior to the stated maturity date is referred to as a callable bond.

• The price that the issuer must pay to retire the issue is the call price.

• Bonds can be called in whole or in part. Most of the time, an entire bond issue is called. When only part of an issue is called, the bond certificates to be called are selected randomly or on a pro rata basis. This means that each bondholder will have the same percentage of his or her holdings redeemed.

• Typically, call provisions have a deferment period; that is, the issuer may not call the bond for a number of years until a specified first call date is reached. This feature is called a deferred call.

• The issuer has no obligation for early retirement of bonds.

A call option becomes more valuable to the bond issuer when interest rates fall. If interest rates fall, the issuer can retire the bond paying a high coupon rate, and replace it with lower coupon bonds. However, call provisions are detrimental to bondholders, since proceeds can only be reinvested at a lower interest rate.

Callable bonds exercise styles:

• American call: any time starting on the first call date
• European call: once on the call date
• Bermuda-style call: on predetermined dates following the call protection period

Putable Bonds

A put option grants the bondholder the right to sell the issue back to the issuer at a specified price ("put price") on designated dates. The repurchase price is set at the time of issue, and is usually par value.

Bondholders have the option of putting bonds back to the issuer either once during the lifetime of the bond (a "one-time put bond"), or on a number of different dates. The special advantages of put bonds mean that putable bonds have lower yield than otherwise similar bonds.

The price behaviour of a putable bond is the opposite of that of a callable bond. The put option becomes more valuable when interest rates rise.

Convertible Bonds

A convertible bond is an issue that grants the bondholder the right to convert the bond for a specified number of shares of common stock. This feature allows the bondholder to take advantage of favorable movements in the price of the issuer's common stock without having to participate in losses.

Example

Suppose you can buy a 10%, 15-year, $100 par value bond today for $110 that can be converted into 10 shares at $10 per share. The market price of stock = $8; no dividends.

• The conversion price is the price per share at which a convertible bond can be converted into common stock. In the example above, the conversion price would be $10.

• The conversion ratio is the number of common shares each bond can be converted into (in this case, 10). It is the par value / conversion price. It is determined at the time the convertible bond is issued.

• The conversion value, also known as parity value, is the market price of stock x conversion ratio ($8 x 10 = $80).

• The conversion premium is the difference between the bond's price and its conversion value ($110 - $80 = $30). Conversion parity occurs when the conversion premium is zero (here, when the stock price is $11 ($11 x 10 = $110)).

Warrants are securities entitling the holder to buy a proportionate amount of stocks at some specified future date at a specified price. They are similar to call options.