call premium

(noun)

the additional cost paid by the issuer for the right to buy back the bond at a predtermined price at a certain time in the future

Related Terms

Examples of call premium in the following topics:

  • Deciding to Refund Bonds

    • Refunding occurs when an entity that has issued callable bonds calls those debt securities to issue new debt at a lower coupon rate.
    • Refunding occurs when an entity that has issued callable bonds calls those debt securities from the debt holders with the express purpose of reissuing new debt at a lower coupon rate.
    • This involves computing the after-tax call premium, the issuance cost of the new issue, the issuance cost of the old issue, and the overlapping interest.
    • The call premium is a cash outflow.

  • Call Provisions

    • In other words, on the call date, the issuer has the right, but not the obligation, to buy back the bonds from the bond holders at a defined call price.
    • Call dates are the dates on which callable bonds can be redeemed early.
    • A European callable has only one call date.
    • An American callable can be called at any time until the maturity date.
    • With some bonds, the issuer has to pay a premium, known as the call premium.

  • Options Contract

    • Option holders must pay a fee, called the option premium.
    • If the spot market price rises, subsequently, the option's premium for a European call option increases while the premium decreases for the put option.
    • If the strike price increases, then the option's premium for a European call option decreases while the premium increases for a put option.
    • Consequently, the option issuer charges a greater option premium for both calls and puts.
    • Thus, this investor would not exercise the call option, but a speculator would earn a loss, which equals the premium.

  • The Term Structure

    • The expectation hypothesis of the term structure of interest rates is the proposition that the long-term rate is determined by the market's expectation for the short-term rate plus a constant risk premium.
    • This is called the term premium or the liquidity premium.
    • This premium compensates investors for the added risk of having their money tied up for a longer period, including the greater price uncertainty.
    • Because of the term premium, long-term bond yields tend to be higher than short-term yields, and the yield curve slopes upward.
    • Long-term yields are also higher not just because of the liquidity premium, but also because of the risk premium added by the risk of default from holding a security over the long-term.

  • Chapter Questions

    • You are holding 10 call options for petroleum with a strike price of $75 per barrel.
    • Option premium equals $0.5 per barrel, and each contract specified a quantity of 1,000 barrels.
    • Compute the premium, and whether you will exercise this option if the market price is $50 per barrel?
    • Strike price of corn equals $5 per bushel; the option premium is $0.01 per bushel, and each contract specified a quantity of 100 bushels.
    • Calculate the farmer's premium, and whether he will exercise this option if the market price of corn equals $6 per bushel?

  • The Yield Curve

    • The expectation hypothesis of the term structure of interest rates is the proposition that the long-term rate is determined by the market's expectation for the short-term rate plus a constant risk premium.
    • The liquidity premium theory asserts that long-term interest rates not only reflect investors' assumptions about future interest rates, but also include a premium for holding long-term bonds (investors prefer short term bonds to long term bonds), called the term premium or the liquidity premium.
    • This premium compensates investors for the added risk of having their money tied up for a longer period, including the greater price uncertainty.
    • Because of the term premium, long-term bond yields tend to be higher than short-term yields, and the yield curve slopes upward.
    • Long term yields are also higher not just because of the liquidity premium, but also because of the risk premium added by the risk of default from holding a security over the long term.

  • Contractual Saving

    • Insurance companies provide protection for people who buy insurance policies.Insurance policy prevents financial hardship, such as a medical emergency, car accident, or the death of a family member.Insurance companies are financial intermediaries because they link the funds from the policyholders to the financial markets.Policyholders make periodical payments to the insurance company called premiums.Insurance company will invest the premiums in the financial
    • markets.For the insurance company to earn a profit, the amount of interest earned in the financial markets plus the total amount of premiums must exceed the amount paid for claims.Largest insurance companies include Allstate, Aetna, and Prudential.Most states established commissions that regulate insurance companies.Commissions may limit premiums, minimize fraud, and prevent the insurance companies from investing in risky securities.
    • Insurance companies use two strategies to combat moral hazard and adverse selection.First, insurance companies gather information about the policyholders, such as driving records, medical records, and credit histories.Consequently, the insurance company charges a higher premium to a person who is likely to file a claim, which we call a risk-based premium.Second, insurance companies use a deductible.When a person makes a claim, the person must pay the first portion.For example, a person buys health insurance with a $500 deductible.After this person has paid the first $500 to a doctor, then the insurance company pays the remainder of the claim.This passes some of the responsibility to the person holding the insurance policy.Finally, a person could buy insurance with smaller premiums but with a greater deductible.
    • First type of insurance company is a life insurance company.These companies purchase long-term corporate bonds and commercial mortgages because they can predict future payments with high accuracy.Furthermore, the insurance companies are organized in two ways: Mutual company or stock company.Insurance policyholders own a mutual company because the insurance policy functions as corporate stock, while a stock company is a corporation that issues stock.Thus, the shareholders own the company, while the insurance policyholders do not.Stock company is more common because a stock company has more funding sources.They receive funding by selling stock to shareholders, and receive revenue by selling insurance policies.Most policies issued are called term life policies.Person buying the life insurance must pay the premium for the rest of his life.These policies are popular because the policyholder can borrow against the value of the life insurance policy, when he retires.Borrowing against insurance is an annuity.An annuity pays a retired person a specific amount of money each year.
    • Second type of insurance company is property and casualty insurance companies.They are organized as either a stock company or mutual company, and they insure against theft, floods, illness, fire, earthquakes, and car accidents.These companies tend to purchase liquid, short-term assets because these companies cannot accurately predict the amount of future claims.Insurance companies charge premiums that correspond to the chance of the event occurring.For example, a homeowner in California would pay a higher premium for earthquake insurance than a homeowner in the Midwest of the United States because California experiences more earthquakes.

  • Default Risk and Bond Price

    • Then economists can plot the term structure, called the yield curve.
    • Economists call the difference between the interest rate on the U.S. government bonds and corporate bonds the default risk premium.Investors add default risk premium to a risk-free investment, so they can invest in "risky" bonds because they earn a greater return.
    • Risk premium is always positive.
    • As the default risk increases, then the risk premium increases too.
    • Impact of a risk premium on the bond markets

  • The "Bond Yield Plus Risk Premium" Approach

    • The risk premium on its equity is 4%.
    • The normal historical equity risk premium for all equities has been just over 6%.
    • In general, an equity's risk premium will be between 5% and 7%.
    • Common methods for estimating the equity risk premium include:
    • Describe the process for the bond yield plus risk premium approach

  • Special Derivatives

    • For example, the Chicago Board of Options Exchange (CBOE) offers options on the Dow Jones Industrial Average, which it calls DJX.
    • Since no commodities are exchanged, the financial companies offer call and put options on the stock market indices.
    • Thus, the option premiums became pure profits to Barings.
    • Consequently, the investment banks would collect CDS premiums as pure profit.
    • Gamblers only pay the CDS premiums.