What Is a Call Premium?
Are you being rewarded for the investment risk you’re taking on?
This reward for risk is often referred to as the premium. With certain types of investments, particularly bonds and options, you may also hear the term “call premium.”
All investing comes with some risk. And as an investor, you should seek to be rewarded for that risk. Ideally, investments with higher risk should come with higher potential rewards.
What Is a Call Premium?
When investing in bonds, the call premium is the compensation you receive in exchange for a bond being taken off the market before it matures. When investing in options, the call premium is another term for the price.
How Call Premiums Work in Bonds
As an investor, you run the risk of losing a bond before it matures. When this happens, you lose out on whatever income that bond might produce.
Provisions that allow a borrower to call a bond, or redeem it before it matures, may not allow an investor to hold onto the bond full term. Usually, this happens when interest rates decline.
Fortunately, investors can get additional money as compensation for the risk of a bond being called back. This compensation is referred to as a "call premium." The 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.
Any company that issues bonds to help fund its operations wants to pay the lowest interest rate that it can. Thus, it may choose to essentially swap out existing bonds with new ones when rates decline.
So, for example, let’s 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. Usually, there are windows of time when bonds can be called back in this way.
When a bond is called, the investor loses out any future income from that bond. In the example above, if a 10-year bond is redeemed after five years, the bondholder will receive no payments for the last five years of the bond’s term. To make matters worse, if the investor chooses to buy new bonds, they may not earn as much because interest rates are likely lower.
To compensate investors for this potential loss of income, many bondholders will issue premium payments as a reward. The premium is usually the difference between the bond’s purchase price and the call price. Still, there are other considerations, including the time until the bond matures, and the overall conditions of the market.
How Call Premiums Work in Options
The call premium is another term for the price of an option. When trading options, you are essentially 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 call premium, in this case, is the price you pay to obtain this right.
To illustrate this, let’s say you 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. Let’s say 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. In this case, we’ll say the premium is $1 per share, or $100. So while you can buy $5,500 worth of Coca-Cola stock for $4,500, you must then pay $100 to the seller as a premium.
To calculate the proper premium on an option, you must first determine the option’s intrinsic value and time value.
The intrinsic value is the difference between the original price of the asset and its strike price. So in the above example, the price of Coca-Cola stock rose to $55, but the strike price was $45. Thus, the intrinsic value is $55 minus $45, or $10.
The time value is equal to the premium minus the intrinsic value. Time value is generally higher when there is more time left before an option expires.
Call premiums may also be adjusted depending on how volatile a stock is.
The premium or cost of an option can be calculated with the following formula:
Price = Intrinsic value + time value + volatility value.
Based on this, we can generally determine how the call premium might rise and fall:
- A call premium may decline as the expiration date of an option approaches. That’s because the less time an option has until it expires, the smaller the chance the investor will make money.
- A more volatile stock will mean a higher call premium. In this instance, the seller is being compensated for the challenge in predicting how a volatile stock will perform.
The Bottom Line
Call premiums are paid to investors as compensation for the risk of having a bond called early or an option sold. When this happens, investors should understand how premiums are calculated. For bonds, investors need to know the face value of the bond, market volatility, and other factors that will determine the premium. For options, investors should know the intrinsic value, time value, and volatility value that is used to calculate the cost of selling an option.