Definition§
1. Options Market§
A call premium is the amount the buyer of a Call Option has to pay to the seller (writer) in excess of the current market price. This premium grants the buyer the right, but not the obligation, to purchase a stock or stock index at a specified price (strike price) before a specified date (expiration date).
2. Bonds and Preferred Stock§
In the context of bonds and preferred stock, the call premium refers to the amount over the par value that an issuer is required to pay to an investor for redeeming the security early. This premium compensates investors for the risk and inconvenience of having their investment redeemed before maturity.
Examples§
Options Market§
- Equity Option: An investor buys a call option on XYZ Corporation’s stock. The current market price of XYZ is $50. The strike price of the call option is $55, and the call premium is $3. The total cost for the investor to purchase the option is $3 above the current price.
Bonds and Preferred Stock§
- Callable Bond: A company issues a callable bond with a par value of $1,000 and a call price of $1,050. If the company chooses to redeem the bond early, it must pay the bondholder $1,050, which includes a $50 call premium.
Frequently Asked Questions (FAQs)§
Q1: Why do investors pay a call premium in stock options?
A1: Investors pay a call premium for the potential upside of purchasing a stock or stock index at a strike price lower than its future market price. The premium also accounts for market volatility and the time value of the option.
Q2: What factors affect the call premium in an option contract?
A2: Factors affecting the call premium include the current stock price, the strike price, the remaining time until expiration, the stock’s volatility, and the risk-free interest rate.
Q3: Can the call premium change over the life of the option?
A3: Yes, the call premium can vary over time due to changes in the underlying asset’s price, volatility, and time decay as the option approaches expiration.
Q4: Why do bonds have call premiums?
A4: Call premiums on bonds compensate investors for the risk of early redemption, which often occurs in a declining interest rate environment where issuers can refinance at lower rates.
Q5: How is the call premium on bonds determined?
A5: The call premium is usually specified in the bond’s indenture and may be a fixed amount or a percentage of the par value.
Related Terms§
Call Option§
A financial contract that gives the holder the right to buy a certain quantity of an asset at a specified price within a specified time period. The buyer pays a premium for this right.
Strike Price§
The specified price at which the holder of a call option can buy the underlying asset during the option’s life.
Par Value§
The face value of a bond or preferred stock, which is the amount paid back to the investor at maturity or early redemption.
Expiration Date§
The date on which an options contract expires and the right to exercise it no longer exists.
Online References§
Suggested Books for Further Studies§
- “Options, Futures, and Other Derivatives” by John Hull
- “Options Made Easy: Your Guide to Profitable Trading” by Guy Cohen
- “The Bond Book: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More” by Annette Thau
Fundamentals of Call Premium: Finance Basics Quiz§
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