What Is a Call Premium?

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DEFINITION

A call premium is the amount investors receive if the security they own is called early by the issuer.

Definition and Example of Call Premium

Call premiums are common in the bond market. Bonds are debt instruments that are usually issued by corporations and governments.

In return, the borrower or issuer typically pays investors interest over the life of the bond and returns the principal (original amount invested) to the bondholder on the bond's maturity date. Sometimes, a bond can be structured so that the issuer can redeem the bond early or before its maturity.

Call Premium

For securities that can be called, such as bonds, the call premium is the money you receive when a bond is redeemed early by the issuing party.

When a security is taken off the market before it matures, holders of that security lose out on the income that would have been paid to the investor. As a result, the issuer pays a call premium to make up for some of that lost income.

When you invest money, the reward for risk is often called the premium. A call premium is a reward for the risk you take when you buy investments that can be called or redeemed early.

  • Alternate definition: When you invest in options, the call premium is another term for the price of the call option.
  • Alternate name: redemption premium.

Example of Call Premium

Suppose a firm has issued a series of 10-year corporate bonds paying a 5% interest rate. After five years, overall interest rates have decreased to 3%. The company may choose to buy back the bonds issued at 5% and issue new bonds at the lower rate. Since investors would lose 2% of interest income, the company could pay a call premium.

If the bond typically costs $1,000 to purchase, the bond might be callable at $1,020, so the $20 is the call premium. As a result, the investor would be paid a 2% premium ($20 ÷ $1,000) above the bond's face value if it were called early.

How a Call Premium Works

Many bonds are issued with plans that allow a borrower to call the security. This means they would redeem it before it matures. When you buy a bond, there may also be a plan to prevent investors from holding on to the security for its full term. The issuer has the option to call the bond before it reaches the maturity date.

Any firm that issues bonds to help fund plans it has for growth or improvement wants to pay the lowest interest rate that it can. To keep rates low, it may choose to swap out current bonds with new ones when rates decline.

In most cases, there are windows of time when bonds can be called back by their issuers.

Callable securities present more risk for investors than non-callable securities. If they are called, investors can lose money in two ways:

  1. The investor loses out on the added income that would have been made between the call date and the maturity date.
  2. If the investor buys new bonds, they may not earn as much, because interest rates are lower.

A call premium is paid to investors to make up for the risk of a bond being called. The premium is usually based on:

  • The difference between the bond’s purchase price and the call price.
  • Amount of time until the bond matures.
  • Overall conditions of the market.

The call premium usually pays out about one year of interest but could be higher or lower. The exact amount depends on how many years are left before the bond’s maturity date.

Types of Call Premiums

The call premium is also a term for the price of an options contract.

When trading call options, you are buying contracts that allow you to purchase shares of a firm at an agreed-upon price, which may not match its price on the open market. The premium of the call option, or the call premium, is the upfront price you pay to obtain the call option.

Typically, call premiums are set based on the value of the company, how much time is remaining before the option expires, and the volatility or price fluctuations of the stock price.

Example of a Call Option Premium

You might enter a contract that gives you the right to buy 100 shares of Coca-Cola stock for $45 per share by June 1. The $45 is the strike price. If the stock price rises to $55, you can exercise the right to buy the shares at $45 per share. In turn, you can sell the shares in the open market for $55, earning a $10 profit minus the cost of the call premium.

To have the right to use this option, you must pay a premium to the seller. If the premium is $3 per share, you would pay $300. You are able to buy $5,500 worth of Coca-Cola stock for $4,500 plus a premium of $300 to the seller.

Call Option Premium's Characteristics

Typically, the amount or value of a call premium will:

  • Decline as the expiration date of an option gets closer, since the chances of the investor making a profit on the contract decrease.
  • Increase for a volatile stock, because the likelihood of the stock price moving beyond the strike price is increased, making the contract more likely to be profitable. The option seller is compensated for the challenge of predicting how the stock will perform.

Is a Call Premium Worth It?

All investing comes with risks. Knowing how much risk you can take is a key aspect of determining where you should invest your money.

Call premiums are a way of paying investors for the risk they are taking and keeping their losses down. If you are unsure whether securities with a call premium are investments that you feel comfortable investing in, you can talk to a financial advisor to assess your risk tolerance.

Key Takeaways

  • A call premium is the amount that investors receive if the security they own is called early by the issuer.
  • A call premium is a payback for the risk of lost income.
  • Callable securities, such as bonds, are often called when interest rates fall.
  • A call premium is also another name for the price of call options.

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