Embedded option

An option written into a bond's terms, such as the issuer's right to call it or the holder's right to put or convert it. Its value is the gap between the bond's price and that of an option-free bond.

Where you will meet it

Embedded option appears in 10 learning outcomes on the CFA syllabus. A few of them:

• Contrast the Z-spread with the option-adjusted spread
  CFA Level I · Fixed Income

  “The option-adjusted spread takes the Z-spread and removes the value of any embedded option, using an interest rate model.”

• Explain bonds and other debt securities that contain embedded options
  CFA Level II · Fixed Income

  “Embedded options give one party a right that changes the bond's cash flows.”

• Discuss relative value hedge fund strategies: their investment features, how they are put into practice and the role they play in a portfolio
  CFA Level II · Alternative Investments

  “Convertible bond arbitrage buys convertibles whose embedded options look cheap and shorts the issuer's shares in proportion to the option's delta, earning coupon income and trading gains around the hedge.”

• Weigh the strengths and weaknesses of the different spread measures used in credit portfolios, and show why the option-adjusted spread is the measure of choice
  CFA Level III · Portfolio Management Pathway

  “The Z-spread is the constant spread over each spot rate that prices the bond, so it reflects the whole curve, but for a bond with an embedded option it still includes the option's value.”

See also

Option-free bond

Practise it

• Today's practice question One question, with every wrong option explained.
• Free Level I diagnostic test Twelve questions that show which topics to start with.
• Free finance calculators Check your arithmetic on the exam's core formulas.

All terms beginning with E · Glossary