The call premium is the amount by which a bond or preferred stock’s call price exceeds its par value. For instance, a bond with a par value of $1,000 and coupon interest rate of 10% would be callable for $1,100 [$1,000 + ($1,000 x 10%)]. The call premium, in this case, would be $100 [$1,100 – $1000].
It is basically the amount that investors receive if the security they own is called before its scheduled maturity by the issuer. In other words, a call premium is actually the difference between a bond’s face value and its call price.
A call premium is also referred to as a redemption premium. In the context of a call option, the call premium is the amount that the buyer of an option is required to pay to the option writer.
How Call Premium Works?
Most preferred shares and corporate bonds have call clauses in their contracts that enable the issuer of the securities to redeeming them before they mature. Securities having this feature are known as callable securities. For example, when a bond is classified as callable then it means the issuer of the bond has the right to call the bond when its rate of interest declines.
Using the above example, the bond will get redeemed before its original maturity date by the issuer so that advantage can be taken of lower interest rates in markets through refinancing of its debt. Basically, the issuer calls its securities to have high-interest rates and re-issues securities with lower interest rates. This helps the borrower in reducing its cost of borrowing. While this is beneficial for the issuer of the bond, it exposes the holder of the bond to the risk of reinvestment which can be described as the risk of reinvesting in security having a lower interest rate. In addition, the holders of the securities that get redeemed by its issuers before their scheduled maturity, stop receiving interest payments. For example, a company holds a 5-year bond (5% interest rate per annum) that is called by its issuer after just 2 years meaning the company will not receive interest payments for the remaining 3 years. If security is called by the issuer then in such a scenario the holder of that security will be compensated by the issuer in the form of a call premium for depriving the holder of its future interest income.
For securities that don’t have the call feature or securities that are redeemed during the period in which the holders of the securities are protected from the call provision, the call premium represents the penalty which the issuer pays to the holders of the securities. During the period in which an issuer is allowed to call security, the call premium is generally equal to the amount of 1 year’s interest.
Types of Call Premium
Apart from a call premium for securities that are considered to be callable, there is also a call premium related to a call option. A call option can be described as a financial contract that provides the buyer the option to buy a particular number of shares for an agreed purchase price. The premium, in this case, represents the amount paid by the buyer to the writer (seller) of the option to obtain/ claim this right.
Call Option Premium Example
Let’s assume that an investor purchases an October 20, 2020 call option on 100 ABC shares for a price of $160 per share. If by October 20, 2020 the price of ABC shares exceeds $160 then the investor may exercise the option it has to purchase 100 shares of Company ABC at $160 each. However, an investor must pay a call premium in order to attain the rights attached with a call option. Using the data above, the premium for one share of ABC is $3.5 which means the writer would receive $350 on the redemption of the aforementioned call option.