The world of stocks and bonds can be full of jargon that makes it hard for inexperienced investors to understand what's going on. Although the terms can be confusing, breaking them down can help even investors with little experience understand their rights and responsibilities as investors.
Many investors are attracted to bonds, which offer a certain amount of interest over a set period of time. Generally, bonds are considered a very safe investment, and investors know exactly how long they'll be receiving payments. This makes bonds a popular investment option, particularly for beginners.
However, most bonds include a provision that the issuing entity, like a government or company, has the option to call the bond early. That means that if interest rates drop, the issuing entity can call the bond (which means pay it off) and reissue debt at a lower interest rate in order to save money. Although this is beneficial for the issuing entity, it deprives the investors of future earnings. To make up for this loss, a call premium is paid.
What is a Call Premium?
A call premium is essentially the cost of paying a bond off early. It is an amount in addition to the face value of the bond that is paid if the bond is called before its maturity date. If a bond is called early, the issuing entity must pay a call premium to the investors who have underwritten the bond. This is because investors are losing out on the interest that they would have been paid if they had held the bond for the entire time for which it was originally issued. In general, the call premium is highest in the early years of a bond because investors will lose out on more interest if it's paid early, and it decreases with time. When a bond is mature, the call premium is zero.
How is Call Premium Calculated?
Call premium is calculated using the face value of the bond (also known as the par value), the amount of time left until maturity of the bond, the underlying volatility of the market, the risk-free interest rate and the strike price, which is the price at which the bond can be called per the terms of the agreement. Other factors can also contribute to the bond call premium. An online calculator is useful for determining the call premium.
Consider this call premium example. You hold 100 shares of Stock X, and each has a call option of $6.50 when they are called. You would be paid $650 over the face value of the stock because the investment you've made is essentially being repaid early.
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