An embedded option [1] is a component of a financial bond or other security, which provides the bondholder or the issuer the right to take some action against the other party.
A bond may have several options embedded if they are not mutually exclusive.
Securities other than bonds that may have embedded options include senior equity, convertible preferred stock and exchangeable preferred stock.
[citation needed] The valuation of these securities couples bond- or equity-valuation, as appropriate, with option pricing.
Calculating rate-sensitivities on these instruments is complicated: the embedded features make measures such as duration and convexity (and DV01) less meaningful; and analysts instead use effective duration and effective convexity.