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 are Interest Rate Options?3 Views
Finance Allah Shmoop What are interest rate options All right
people you may need a big loan in three years
It's all about the storms And the big sees you
know with the amount of destruction they'll do to the
oil rigs you manage out there right you big oil
company Global warming has in fact changed weather patterns So
you have no idea if you'll actually need five billion
dollars in debt to buy and or build a new
one But today you mister or missus or Miss CEO
today interest rates are cheap The Fed is almost giving
away money in two and a half percent interest which
means that you can get a loan at Summit for
ish percent interest rate since so much money is involved
here like five billion dollars Well the move of one
percent or one hundred basis points is big and times
were good now and well you really want certainty So
in order to reduce risk you buy an interest rate
option that is You pay one hundred million dollars for
the right three years from now too Then get alone
of call it three billion dollars and note that you
don't have to get the full five billion dollars if
rates go up in the last two billion is expensive
money while fen you figure inflation has hit big time
and you can just well raise prices on oil and
you know or your services to the big oil Cos
right because that's what you do for a living That
hundred million dollars is a call option on future interest
rates that well may or may not be there right
Like it might expire worthless Or it might be worth
a fortune if rates or seven eight nine percent So
what happens if the Fed doesn't budge and rates are
identical in three years Toe what they are today you
lose it All right You lose all hundred million dollars
for that call option You bought Goldman Sachs or Morgan
Stanley or whatever Big Bank took the risk on the
other end of that trade Just made one hundred very
large just for you know being there But you don't
feel bad about it Why Well because interest rates are
still then super cheap At four percent it's kind of
like term life insurance only for the finance world Piccoli
for big oil companies or big capital expense kind of
cos every month that goes by and you lose the
fifty eight bucks you spent on that million dollar policy
you personally bought for your wife and kids If you
get hit by a bus well you feel good to
have wasted that fifty eight dollars because well the alternative
is you know that you don't have a life You
know we don't just mean that Then your social calendar's
empty And your best friends are your Star Wars action 00:02:26.92 --> [endTime] figures no
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