An embedded option is a provision in the 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 benefit.

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 which the issuer must pay to retire the issue is the call price.
• Bonds can be called in whole or in part.
• Typically, call provisions have a lockout period; that is, the issuer may not call the bond for a number of years until a specified first call date is reached.
• The issuer has no obligation for early retirement.

A call option becomes more valuable to the bond issuer when interest rates fall. For example, if interest rates fall, the issuer can retire the bond paying high coupon rate, and replace it with lower coupon bonds. However, call provisions are detrimental to the bondholders as the 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 lockout period.

Putable Bonds

A put option grants the bondholder the right to sell the issue back to the issuer at a specified price (called 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 (known as 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.

An extendible bond gives the bondholder the right to extend its maturity date by a number of years. Such a bond may be considered as a portfolio of a straight, shorter-term bond and a call option to buy a longer-term bond. Because extendible bonds contain an option to extend the maturity period, a feature that adds value to the bond, they sell at a higher price than non-extendable bonds.

Complex Embedded Options

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. The 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 on the stock.

A bond with an estate put can be put by the heirs of a deceased bondholder.

In most cases, a sinking fund requires the issuer to actually retire a portion of the debt on a prearranged schedule so that all of the debt is retired by the maturity date.

The importance of options embedded in a bond issue:

• They affect the value of a bond, as well as the performance of a bond measured by the rate of return. They affect both the timing and the level of the future cash flows from the bond.
• Because of the embedded options, it is necessary to develop models of interest rate movements and rules for exercising these options. Such models are typically based on a number of assumptions.
• Investors are exposed to the risk that the valuation models may produce the wrong value due to incorrect assumptions. Such a risk is called the model risk.