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An embedded option is a component of a financial bond or other security, and usually 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. Some 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.
The valuation of these securities combines bond- or equity-valuation, as appropriate, with option pricing. For bonds here, there are two main approaches: (1) Depending on the type of option, the option price, as calculated using Black Scholes, is either added to or subtracted from the price of the "straight" bond (i.e. as if it had no optionality) and this total is then the value of the bond. (2) A bespoke "tree" (usually a lattice based short rate model) may be constructed where the option's effect is incorporated at each node in the tree, affecting either the bond price or the option price as specified; see further under bond option. Once the price has been calculated, the various yields can then be calculated for the security. Other securities with embedded derivatives are priced similarly.
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