Usually callable bonds (or preferred stock) come with a feature where the issuer can buy back the bonds from the investor before the actual maturity date. This feature is given so that issuers can benefit if interest rates in the market drop drastically (by calling back the bonds and issuing new bonds at low interest rates). Callable bonds also attract investors as they have higher coupon rates when compared to non-callable bonds. The higher coupon rate is given in lieu of the interest payments that they may lose if the bonds are called back before the maturity date.
Usually call price lowers closer to the maturity date. This is based on the simple concept of time value. Earlier the recall, more will be the premium paid by the issuer.
Consider a 2-year bond issued at face value $100 and call price $120.
Call Price ($)
100 (=Face Value)
Call Option Price:
In the context of an option, call price refers to the price of a call option, which includes both its intrinsic value and time value.
Intrinsic value is dependent on the actual gain on the option, which in turn is based on the exercise/strike price and spot price. For a call option, a buyer makes money when spot price, S0, is greater than strike price, X, i.e. when he/she gets to buy at a price lower than spot price. If S0 is lower than X, the buyer chooses not to exercise the option.
Hence, Intrinsic Value = Max (0, S0-X).
Time Value is the component of the call price that is associated with the uncertainty of the price movement given the time to expiry. Hence, closer the time to expiry, lower is the time value of the option. On the date of maturity, time value component = 0.
As expiration approaches, time value gets close to 0 and the call price curve approaches the intrinsic value curve.