An embedded option [1] is a component of a financial bond or other security, which provides the bondholder or the issuer the right to take some action against the other party. There are several types of options that can be embedded into a bond; common types of bonds with embedded options include callable bond, puttable bond, convertible bond, extendible bond, exchangeable bond, and capped floating rate note. A bond may have several options embedded if they are not mutually exclusive.
Securities other than bonds that may have embedded options include senior equity, convertible preferred stock and exchangeable preferred stock. See Convertible security.
The valuation of these securities couples bond- or equity-valuation, as appropriate, with option pricing. For bonds here, there are two main approaches, as follows.[2] Other securities with embedded derivatives are priced similarly.
Once the price has been calculated, the various yields can then be calculated for the security.Calculating rate-sensitivities on these instruments is complicated: the embedded features make measures such as duration and convexity (and DV01) less meaningful; and analysts instead use effective duration and effective convexity.