If the issuers of the underlying security of an option call early, the investors lose some money. A call premium is a compensation paid by the issuers to make up for the gap or loss suffered by the option holders. The premium is meant to balance the risk option owners face while the underlying is exercised earlier than its maturity period.
Some securities, such as bonds have the luxury to be called early. If such securities are kept as the underlying in an option, they may be called earlier than the deadline of the security. This leads to some losses to the option owner. Therefore, the issuer of the option pays a premium to offset the losses. This is called a call premium.
In the case of all financial investments, there is a risk-reward relationship – you get a reward if you take a risk. In the case of call options, if the security underlying is taken off the market, there is a risk the investors follow. The issuer, therefore, pays them a premium or a reward for taking the risk of owning securities that can be redeemed earlier than its maturity or deadline.
Many bonds are issued with plans that allow the investors to redeem the bond before maturity. Alternately, the issuers of bonds may stop investors from holding the bonds until the date of maturity. To do so, they add some terms in the bond to make it redeemable before it reaches maturity.
Also, issuers of bonds always try to keep the interest rates low. So, in the case of a bond that has reached a certain interest rate may be swapped by a new bond by the issuers that has a lesser interest rate.
Callable securities that are chosen as the underlying asset have more risks than non-callable ones. If the securities are called, investors may lose money in the following ways −
The investor loses income from the remaining timeframe. This means, as the timeframe is cut short, the interest income gets reduced automatically.
The investors may now buy new bonds but they may not pay as much as the original bonds that have been redeemed at a lower cost.
A premium is paid to the investors to make up for the losses he or she makes. The premiums are usually based on
Difference between the purchase price and call price of the security.
Time remained until the maturity of the bond (Time Value of the security).
Overall market condition and the market price of the underlying assets.
Usually, the call premium pays about one year’s interest, however, it may go up or down depending on the time value and price of the bond.