Call Premium
What is a Call Premium?
Call premium is the difference between a bond’s par value and call price.
![cp 1](https://seeaccountingnow.online/wp-content/uploads/2021/08/cp-1.jpg)
How it Works
When a corporation issues a bond, it issues the bond around current interest rates.
![cp 2](https://seeaccountingnow.online/wp-content/uploads/2021/08/cp-2.jpg)
This means it will pay the current rate of interest each year—over the bond term.
![cp 3](https://seeaccountingnow.online/wp-content/uploads/2021/08/cp-3.jpg)
However, when issuing the bond, the corporation may be concerned there is a chance interest rates will fall in the next year or so.
![cp 4](https://seeaccountingnow.online/wp-content/uploads/2021/08/cp-4.jpg)
Should this happen, the corporation will be locked into paying a higher rate of interest than prevailing interest rates.
![cp 5](https://seeaccountingnow.online/wp-content/uploads/2021/08/cp-5.jpg)
To guard against such an event, the corporation may issue their bond with an embedded call price option.
![cp 6](https://seeaccountingnow.online/wp-content/uploads/2021/08/cp-6.jpg)
If interest rates do fall, the bond’s price will rise.
![cp 7](https://seeaccountingnow.online/wp-content/uploads/2021/08/cp-7.jpg)
In this event, the corporation can exercise the call option.
![cp 8](https://seeaccountingnow.online/wp-content/uploads/2021/08/cp-8.jpg)
This is like buying the bond back at the strike price.
![cp 9](https://seeaccountingnow.online/wp-content/uploads/2021/08/cp-9.jpg)
After this, they can re-issue the bond.
![cp 10](https://seeaccountingnow.online/wp-content/uploads/2021/08/cp-10.jpg)
Now, though, they pay a lower interest rate.
![cp 11](https://seeaccountingnow.online/wp-content/uploads/2021/08/cp-11.jpg)
Call Premium
The call premium is the difference between par value and the call price.
![cp 12](https://seeaccountingnow.online/wp-content/uploads/2021/08/cp-12.jpg)
It is how much over and above par value the issuer must pay to redeem the bond in the event they call it.
![cp 13](https://seeaccountingnow.online/wp-content/uploads/2021/08/cp-13.jpg)
How and when the bond may be called is set out in the indenture, which is a legal contract between the borrower and the lender.
![cp 14](https://seeaccountingnow.online/wp-content/uploads/2021/08/cp-14.jpg)
The indenture will also stipulate how much the issuer must pay the investor, should they wish to redeem the bond before maturity.
![cp 15](https://seeaccountingnow.online/wp-content/uploads/2021/08/cp-15.jpg)
Typically, the call price starts off at par plus a year’s interest.
![cp 16](https://seeaccountingnow.online/wp-content/uploads/2021/08/cp-16.jpg)
Then the premium gradually decreases as the bond approaches maturity.
![cp 17](https://seeaccountingnow.online/wp-content/uploads/2021/08/cp-17.jpg)
© R.J. Hickman 2020