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 Derivative?23 Views
finance a la shmoop what is a derivative? well it's derived it's a something taken
from something else like a derivative of hot weather is thirst a derivative of [Girl takes sip of glass of water on a beach]
hunger is well you know crankiness that's diva thing you get there...
derivative of a 1/32 quarterback rating in the NFL is like serious wealth yeah
yeah discount double shmoop yeah look for it be on there with aaron
and a derivative of a stock or bond or other security is a something which
derives its value based on the performance of that underlying security
there are basically two flavors of derivative put options ie the right to [Ice cream flavors appear]
sell a security at a given price over a given time period and a call option, ie
right to buy a security at a given price over a given time period
well the price of that option is derived from the price of the security and a few
other factors like strike prices and duration and all that stuff
colonel electric the downgraded new version of General Electric is trading [Colonel Electric appears in a suit]
for 25 bucks a share a derivative of its share price is sold in the form of a
call option with a $30 strike price expiring about 90 days from now on the
third Friday of the end of that month well investors pay a price albeit
probably a small one for the right to then pay 30 bucks a share for colonel [Call option appears for colonel electric]
electric at any time in the next 90 ish days until that option expires making the bet
that the stock will go well above 30 bucks a share in that time period that
call option is thus a derivative of the colonel electric primary stock price got
it if you really want to get personal well here's the ultimate form of
derivative [Baby laying down]
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