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KembaraXtra – Islamic Derivatives: Examples of Embedded Options in Different Types of Contracts
🔹 What is an Embedded Option (Reminder)
👉 An embedded option is a feature inside a contract that gives one party a right (but not obligation)
👉 It is not sold separately and its cost is included in the contract price
🔹 1. Cancellation Option (Sale Contract)
🔸 Type of Contract:
Sale Agreement
🔸 Example
👉 This right to cancel = embedded option
✔ No separate premium
✔ Cost already included in price
🔹 2. Early Settlement Option (Financing Contract)
🔸 Type of Contract:
Financing / Loan Agreement
🔸 Example
👉 Right to repay early = embedded option
✔ Built into contract
✔ Not traded separately
🔹 3. Convertible Option (Investment Contract)
🔸 Type of Contract:
Bond / Investment Agreement
🔸 Example
👉 Conversion right = embedded option
✔ Included in investment product
🔹 4. Price Adjustment Option (Supply Contract)
🔸 Type of Contract:
Supply Agreement
🔸 Example
👉 Adjustment right = embedded option
🔹 5. Renewal Option (Lease Contract)
🔸 Type of Contract:
Lease Agreement
🔸 Example
👉 Renewal right = embedded option
🔹 Key Idea
👉 In all cases:
🔹 Simple Summary
👉 They give flexibility without separate trading
🔹 What is an Embedded Option (Reminder)
👉 An embedded option is a feature inside a contract that gives one party a right (but not obligation)
👉 It is not sold separately and its cost is included in the contract price
🔹 1. Cancellation Option (Sale Contract)
🔸 Type of Contract:
Sale Agreement
🔸 Example
- A buyer agrees to purchase goods at RM4,000
- Contract allows buyer to cancel within 7 days
👉 This right to cancel = embedded option
✔ No separate premium
✔ Cost already included in price
🔹 2. Early Settlement Option (Financing Contract)
🔸 Type of Contract:
Financing / Loan Agreement
🔸 Example
- A customer takes financing over 5 years
- Allowed to repay early without penalty
👉 Right to repay early = embedded option
✔ Built into contract
✔ Not traded separately
🔹 3. Convertible Option (Investment Contract)
🔸 Type of Contract:
Bond / Investment Agreement
🔸 Example
- Investor buys a bond
- Has the right to convert it into shares later
👉 Conversion right = embedded option
✔ Included in investment product
🔹 4. Price Adjustment Option (Supply Contract)
🔸 Type of Contract:
Supply Agreement
🔸 Example
- Supplier agrees to deliver goods
- Contract allows price adjustment if market changes significantly
👉 Adjustment right = embedded option
🔹 5. Renewal Option (Lease Contract)
🔸 Type of Contract:
Lease Agreement
🔸 Example
- Tenant rents property for 2 years
- Has the right to extend lease for another 2 years
👉 Renewal right = embedded option
🔹 Key Idea
👉 In all cases:
- The option is part of a real contract
- Not a separate traded instrument
- Cost is included in overall agreement
🔹 Simple Summary
- Embedded options exist inside:
- Sale contracts
- Financing agreements
- Investment products
- Lease contracts
👉 They give flexibility without separate trading
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