A call premium is the amount investors receive if the security they own is called early by the issuer. This premium is meant to balance out the risk of lost income. Call premium is also another name for the price of call options.
Learn more about when securities are likely to be called early and how call premiums work.
What Is a 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 party that issued it.
When a security is taken off the market before it matures, holders of that security loses out on the income it would have given. 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.
How a Call Premium Works
Many bonds that 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 onto the security for its full term. The issuer has the option to call the bond before it reaches the mature 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, they may choose to swap out current bonds with new ones when rates decline.
For instance, say a firm has issued a series of 10-year corporate bonds paying a 5% interest rate. After five years, interest rates have gone down to 3%. The company may choose to buy back the bonds issued at 5% and issue new bonds at the lower rate.
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.
- The investor loses out on the added income that would have been made between the call date and the maturity date.
- 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 back. 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 price you pay to obtain the call option.
For instance, 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. This $45 is the strike price. Shares of the company rise to $55, so you exercise the right to buy the shares at $45 per share.
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.
Most of the time, call premiums are set based on the value of the company, how long is left before the option expires, and how up and down a stock is. A call premium for options will:
- Decline as the expiration date of an option gets closer and the chance the investor will make money goes down.
- Increase for volatile stock to pay the seller for the challenge in 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 you feel comfortable making, you can talk to a financial advisor to assess how much risk you can tolerate.
- A call premium is the amount investors receive if the security they own is called early by the issuer.
- This premium is 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.