What is Call Premium?
Call premium refers to the amount that an investor receives when the issuer redeems the security owned by the investor earlier than its maturity. If a security is withdrawn from the market before it reaches maturity, whoever owns the security loses the incremental profits that would’ve been generated. The call premium is the compensation given by the issuer for the lost income of the investor. The call premium is an alternate name given to the value of call options.
- The call premium is the amount that an investor receives when the issuer redeems the security owned by the investor earlier than its maturity.
- The call premium is paid to investors as security for the possibility of calling back a bond.
- When stock options are in-the-money, call premiums generally increase, and when stock options are closing in to be out-of-the-money, the value of call premiums decreases.
Understanding Call Premiums
Many bonds issued with provisions that allow the issuer to call or redeem the security before maturity often include provisions that can prohibit holders from owning the security for the entire term. The lender can opt to call the bond even before it attains maturity.
Any business that issues bonds to help finance its activities seeks to pay the lowest rate of interest possible. Companies can opt to exchange existing bonds with new ones as rates fall. Thus, companies repurchase the bonds paying higher coupons and reissue bonds paying lower coupons. 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 repurchase the bonds that were issued at 4% and then issue new ones at the currently decreased rate of 3%.
Significance of Call Premiums
The term call premium can also be used to refer to the options contract price. When buying call options, investors buy contracts that enable them to buy shares in a company at a negotiated price, regardless of the open market price. 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 will lose money in two ways:
- The investor misses the extra interest payments that they would have gained between the date of the call and the date of maturity.
- Since the interest rate is lower, investors will not gain as much as they do when they buy new shares.
The call premium will be paid to buyers as a security for the possibility of calling back 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 typically pays out an interest of around one year but may be lower or higher based on the number of years left until the bond’s maturity date.
Generally, 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 set on the company’s value, 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 passes, and the investor’s probability of making money declines.
- Increase to compensate the seller for the difficulty of forecasting the performance of an unpredictable stock.
Every investment comes with risk, and understanding the risk tolerance level is a crucial factor 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.
CFI is the official provider of the Capital Markets & Securities Analyst (CMSA)™ certification program, designed to transform anyone into a world-class financial analyst.To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below: