Drop a penny off a 50-story building and watch it hit someone on the street below. Smack! Right in the head. Now that penny is embedded in their scalp. Stuck in tight, such that even the doctor can't extract it...despite the aggressive use of forceps.
That's an embedded penny. Now, to an embedded option. It's stuck into a security, usually a bond. The option and the bond are inseparable...you can't sell the option separate from the bond. You can't pull them apart, even with forceps.
The embedded option gives either the holder or the issuer the ability to take some action in the future.
For example, a callable bond has an embedded option that allows the bond issuer to repurchase the bond under certain conditions.
You run a business that produces fake snow makers for use in indoor ski slopes. You get a big order in Dubai, but you need to borrow some money to get the project going while you wait for payment.
You issue a set of 2-year bonds with an embedded option to call the bonds back if you get paid early. The Dubai ski slope company cuts you a check after 6 months and you exercise your option, calling in the bonds a year-and-a-half before their expiration date.
Related or Semi-related Video
Finance: What Is a Call Option?25 Views
finance a la shmoop. what is a call option? option? option, where are you? okay
yeah yeah. not phone options, call options. and a close but no cigar. a call option [man smokes in a tub of cash]
is the right to call or buy a security. the concept is easy the math is hard.
you think Coca Cola's poised for a breakout as they go into the new low
calorie beverage business. their stock is at 50 bucks a share and you can buy a [man stands on a stage as crowd cheers]
call option for $1. well that call option buys you the right
to then buy coke stock at 55 bucks a share anytime you want in the next
hundred and 20 days. so let's say Coke announces its new sugarless drink flavor
zero it's two weeks later and the stock skyrockets to fifty eight dollars a
share. you've already paid the dollar for the option now you have to exercise it. [man lifts weights]
so you buy the stock and you're all in now for fifty five dollars plus one or
fifty six bucks a share and your total value is now fifty eight bucks. well you
could turn around today and sell the bundle that moment, and you'll have
turned your dollar into two dollars of profit really fast. and obviously had the [equation on screen]
stock not skyrocketed so quickly well you would have lost everything. still you
lucked out and now you're sitting on some serious cash, courtesy of your call [two men in a tub of cash]
options. as for Coke flavor zero turned out to be nothing more than canned water.
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