An option which is added to another instrument as a right to exercise in relation to that instrument. However, embedded options, unlike regular option contracts, don’t trade by their own since they constitute an inseparable part of the respective instrument. These add-on options are actually features granted to holders such as a call provision in corporate bonds or a prepayment possibility in mortgage agreements. Both options allow holders of the original instruments to repay the borrowed money before scheduled maturities.

For example, a callable bond has an embedded short position in a call option. It is as if the bond holder has written a call option to the issuing entity. Therefore, the value of a callable bond equals that of a comparable non-redeemable bond less the value of the embedded call option added to that bond. In the same token, ordinary shares of indebted or leveraged companies (companies that have debts on their balance sheets) can be viewed as shares with embedded options to purchase an unleveraged part of the company by paying off the debt.

In addition to the above type (embedded call option), embedded options may also take the form of embedded put options.