What Is a Call Premium?
Definition & Examples of Call Premium
A call premium is the amount investors receive if the security they own is called early by the issuer. This premium is compensation for 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 callable securities, such as bonds, the call premium is the compensation you receive when the security is redeemed early by the issuer.
When a security is taken off the market before it matures, whoever holds that security loses out on the additional income it would have generated. The issuer pays a call premium to compensate for that lost income.
In investing, the reward for risk is often referred to as the premium. A call premium is a reward for the risk you take in buying callable securities.
- Alternate definition: When investing 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 provisions that allow a borrower to call the security, or redeem it before it matures, also contain provisions that can prevent investors from holding onto the security for its full term. The issuer has the option to call the bond before its maturity.
Any company that issues bonds to help fund its operations wants to pay the lowest interest rate that it can. Companies may choose to swap out existing bonds with new ones when rates decline.
For example, say a company has issued a series of 10-year corporate bonds paying a 5% interest rate. After five years, interest rates have declined to 3%. The company may choose to buy back the bonds issued at 5% and issue new bonds at the lower rate.
There are usually windows of time when bonds can be called back by their issuers.
Callable securities are riskier for investors than non-callable securities. If they are called, investors can lose money in two ways:
- The investor loses out on the additional 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 as compensation 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, depending 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 company at an agreed-upon price, regardless of 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 example, you might enter an agreement 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 execute this option, you must pay a premium to the seller. If the premium is $3 per share, you would pay $100. You are able to buy $5,500 worth of Coca-Cola stock for $4,500 plus a premium of $300 to the seller.
Call premiums are generally adjusted based on the value of the company, how long is left before the option expires, and how volatile a stock is. A call premium for options will generally:
- Decline as the expiration date of an option approaches and the chance the investor will make money decreases
- Increase for volatile stock to compensate the seller for the challenge in predicting how the stock will perform
Is a Call Premium Worth It?
All investing comes with risks. Understanding your own risk tolerance is a key aspect of deciding which investments are right for you.
Call premiums are a way of compensating investors for the risk they are taking and minimizing their losses. If you are unsure whether securities with a call premium are an investment you feel comfortable making, you can talk to a financial advisor to assess your risk tolerance.
- A call premium is the amount investors receive if the security they own is called early by the issuer.
- This premium is compensation 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.