What is a Call Premium?
A call premium refers to the amount above par value an investor receives when the debt issuer redeems the security earlier than its maturity date. If a security is redeemed before it reaches maturity, the owner of the security loses the incremental profits that would’ve been generated.
The call premium is, therefore, the compensation given by the issuer for that lost income. It is also a term used to name the amount paid for a call option.
- The call premium is the amount above par value an investor receives when the debt issuer redeems the security earlier than its maturity date.
- The call premium is paid to investors as compensation for the lost future income on the bond investment.
- For stock options, a call premium is what an investor pays for buying a call option.
Understanding Call Premiums
Many bonds are issued with provisions that allow the security issuer to call or redeem the security before it is scheduled to mature. The securities that include such a feature are referred to as callable securities.
Any business that issues bonds to help finance its activities has the objective of paying the lowest rate of interest possible. Companies, therefore, would choose to exchange existing bonds with new ones as rates fall. Thus, companies will redeem bonds paying higher interest and reissue bonds paying lower interest. The practice essentially reduces the borrowing cost of the company.
For example, suppose Company ABC issued some 10-year bonds providing a 4% interest rate. The interest rate falls to 3% after three years. The company can choose to redeem the bonds that were issued at 4% and then issue new ones at the lower rate of 3%. The cost to Company ABC will be the call premium.
Significance of Call Premiums
The term call premium can also be used to refer to a call option’s contract price. When buying call options, investors buy contracts that enable them to buy shares in a company at a negotiated price in the future. The call option premium, or the call premium, is the amount an investor pays to receive the call option.
For investors, callable securities are riskier than non-callable securities. When called, investors can lose money in two ways:
- The investor is denied the interest payments that they would have received through to the date of maturity.
- The investor will now have to reinvest his money into a market that is paying lower interest rates.
The call premium will be paid to buyers as a security for the calling back of a bond. The premium is generally based on the following:
- The discrepancy between the selling price of the bond and the call price
- The time before the bond matures
- Overall business dynamics
The call premium on debt typically pays out an interest amount of around one year but may be lower or higher based on the number of years left until the bond’s maturity date.
Generally, for call options, the scale and presence of the call premium decide if an investor can earn a profit on a derivative deal. When stock options are in-the-money, call premiums generally increase, and they decrease in value when stock options are closing in to be out-of-the-money. Subsequently, the factors influencing whether a stock option is in or out-of-the-money also affect call premiums.
Call premiums are usually based on the company’s market value, the amount of time left before the expiry of the option, and the volatility level of the stock. A call premium for options usually will:
- Decrease as the expiry date of an option approaches, and the investor’s probability of exercising the option declined.
- Increase to compensate the seller for increased volatility of the underlying security.
Every investment comes with risk, and understanding the individual’s risk tolerance level is crucial in determining which investments are appropriate for individual investors. Call premiums are a way to reward investors for the risk they take and minimize their losses.
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