Call Premiums: What They are, the Different Types

What Is Call Premium?

Call premium is the dollar amount over the par value of a callable debt security that is given to holders when the security is redeemed early by the issuer.

The call premium is also called the redemption premium. In options terminology, the call premium is the amount that the purchaser of a call option must pay to the writer.

How Call Premium Works

The call premium is an amount over the face value of the security and is paid in the event that the security is redeemed before the scheduled maturity date. Put another way, the call premium is the difference between the call price of the bond and its stated par value.

Most corporate bonds and preferred shares have call provisions that permit the security issuer to redeem the securities before they mature. Securities that have this feature are referred to as callable securities. When a bond is callable, the issuer has the right to call in the bonds when interest rates decline.

The existing bonds will be redeemed early and the issuer takes advantage of the attractive lower interest rates in the markets by refinancing its debt issue. In effect, the issuer buys back the higher coupon paying bonds, and reissues bonds with lower coupon rates. This effectively reduces the company’s cost of borrowing.

While this is favorable for the bond issuer, it exposes bondholders to reinvestment risk—the risk of reinvesting their funds in a lower interest-paying bond. In addition, bonds that are redeemed early stop making interest payments to bondholders. For example, an investor holding a 10-year bond that is called after four years will not receive coupon payments for the remaining six years after the bond is redeemed. To compensate callable security holders for the reinvestment risk they are exposed to and for depriving them of future interest income, issuers will typically pay a call premium.

Special Considerations

For noncallable bonds or for a bond redeemed during its call protection period, the call premium is a penalty paid by the issuer to the bondholders. During the first few years that a call is permitted, the premium is generally equal to one year's interest. Depending on the terms of the bond agreement, the call premium gradually declines as the current date approaches the maturity date. At maturity, the call premium is zero.

Types of Call Premium

Besides a call premium for callable securities, there is a call premium related to options. A call option is a financial contract that gives the buyer the right to purchase the underlying shares at an agreed price. The call premium is the price paid by the buyer to the seller (or writer) to obtain this right.

For example, an investor buys a Jan. 20, 2023, call option on Apple (AAPL) with a strike price of $180. If by Jan. 20, the stock price rises above $180, the investor will exercise their option to purchase 100 shares of Apple at $180 each. However, in order to receive the rights associated with a call option, a call premium must be paid to the seller. In this case, the premium for one Apple $180 call option is $15.65 per share (1 contract = 100 shares). Therefore, the call writer (seller) received $1,565 ($15.65 x 100 shares). In order for this transaction to be profitable for the purchaser of the call, however, the price of Apple at contract expiration must be above $195.65 per share to account for the premium paid ($180 + $15.65). This is referred to as the breakeven price.

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