Question

Define Embedded options in debt and explain how it is used to minimize interest rate risk

Answer 1

Embedded options are a particular type of financial security which enable one party to execute a particular action to minimise risk, but subject to ceratin conditions. Embedded options provide an array of solutions to the investments as per their needs. These can be separated from the core value of securities. Embedded options are present in bonds. They are Callable bonds, Puttable Bonds and Convertible Bonds. These bonds help the investors to minimise the risk.

If the interest rate is about to fall, the issuer can call back the bond if it is a callable bond. Thus the interest rate risk can be minimised by using a Callable Bond.

Puttable Bond has a feature of embedded put option. That means the holder of the bond can demand for premature repayment. It is a right for the holder, not obligation. Thus the interest rate risk can be minimised.

Another tool for minimising risk is Convertible Bond. These bonds are convertible to shares or to cash.

Thus Embedded options are used to minimise interest rate risk.