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 stock options in 90 se...0 Views
Finance allah shmoop what are stock options in ninety seconds
or less Here's a stock ibm not the tech company
This one makes an anti constipation drug It's trading at
one hundred eighty bucks a share Okay so here's an
option of buy a share of ibm anytime in roughly
the next three months For one hundred ninety dollars a
share it's called a call option If you really believe
the ibm will go to say two hundred dollars a
share in the next three months well you'd be what's
called ten dollars in the money then or then have
a stock option or call option with a strike price
of one hundred ninety dollars which would then have intrinsic
value of ten bucks a share On the other end
of the buy sell desk is the gal willing to
sell you that call option for three bucks Three bucks
a premium So gut check time Would you pay three
dollars for the right to buy a share if ibm
for ten dollars higher than where the stock's trading now
today Meaning that to break even in the next three
months the stock has to trade all the way up
from one hundred eighty dollars a share to one hundred
ninety three dollars a share jobs for you to get
your money back but it goes to two hundred two
share Well if you sell that option you'll have invested
three bucks a share for a net return of seven
bucks in just three months or less And yes we're
ignoring commissions and taxes here because well in problems like
this or just a in the book but three dollars
into seven only three months Yeah that's a great score
You'd have more than doubled your money And on an
annualized return basis that's over a nine hundred percent dish
return really good score but with a much more likely
case that you spend three bucks to buy the option
and it expires totally worthless And then you've lost your
entire investment in that option So that's a call option
It's evil twin is a put option So whereas a
call options the rightto by a security to set price
by a certain set date a put option is the
right to sell that option We'd go into more detail
here but we're promised ninety seconds
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