Premium Explained: Grasp Its Multi-faceted Role in Finance
Premium has several meanings in finance. Most commonly, it refers to:
- Generically, a security trading above its intrinsic or theoretical value is trading at a premium. The difference between the price paid for a fixed-income security and the security’s face amount at issue is referred to as a premium if that price is higher than par.
- The purchase price of an insurance policy or the regular payments required by an insurer to provide coverage for a defined period of time.
- The total cost to buy an option contract, often synonymous with its market price.
Key Takeaways
- Premium can mean a number of things in finance, including the cost to buy an insurance policy or an option.
- Premium is also the price of a bond or other security above its issuance price or intrinsic value.
- A bond might trade at a premium because its interest rate is higher than the current market interest rates.
- People may pay a premium for certain in-demand items.
- Something trading at a premium might also signal it is over-valued.
Premium Demystified: Beyond the Basics
Broadly speaking, a premium is a price paid above or beyond some basic or intrinsic value. Relatedly, it is the price paid for protection from a loss, hazard, or harm (e.g., insurance or options contracts). The term premium is derived from the Latin praemium, meaning ‘reward’ or ‘prize.’
Types of Premium
Price Premium
A price that exists above some sort of fundamental value is referred to as a premium, and such assets or objects are said to be trading at a premium. Assets may trade at a premium due to increased demand, limited supply, or perceptions of increased value in the future.
A premium bond is a bond trading above its face value, meaning it costs more than the face amount on the bond. A bond might trade at a premium because its interest rate is higher than current rates in the market.
The concept of a bond price premium is related to the principle that the price of a bond is inversely related to interest rates; if a fixed-income security is purchased at a premium, this means that current interest rates are lower than the coupon rate of the bond. The investor thus pays a premium for an investment that will provide returns greater than existing interest rates.
A risk premium involves returns on an asset expected to exceed the risk-free rate of return. An asset’s risk premium is a form of compensation for investors, representing payment for tolerating the extra risk in a given investment over that of a risk-free asset.
Similarly, the equity risk premium refers to an excess return that investing in the stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of equity investing. The size of the premium varies and depends on the level of risk in a particular portfolio. It also changes over time as market risk fluctuates.
Options Premium
Premiums for options refer to the cost to buy an option. Options give the holder the right, but not the obligation, to buy or sell the underlying financial instrument at a specified strike price. The premium for a bond reflects changes in interest rates or risk profile since the issuance date. The buyer of an option has the right but not the obligation to buy (call) or sell (put) the underlying instrument at a given strike price for a given period of time.
The premium paid is its intrinsic value plus its time value; an option with a longer maturity always costs more than the same structure with a shorter maturity. The volatility of the market and how close the strike price is to the current market price also affect the premium.
Sophisticated investors sometimes sell one option (also known as writing an option) and use the premium received to cover the cost of buying the underlying instrument or another option. Buying multiple options can either increase or reduce the risk profile of the position, depending on how it is structured.
Insurance Premium
Premiums for insurance include the compensation the insurer receives for bearing the risk of a payout should an event occur that triggers coverage. The premium may also contain a sales agent’s or broker’s commissions. The most common types of coverage are auto, health, and homeowners insurance.
Premiums are paid for various types of insurance, including health, homeowners, and rental insurance. These payments must be submitted on a regular mode or schedule to maintain policy coverage. A common example involves auto insurance. A vehicle owner can insure the value of their vehicle against loss resulting from accident, theft, fire, and other potential problems.
The owner usually pays a fixed premium amount in exchange for the insurance company’s guarantee to cover any economic losses incurred under the scope of the agreement. Premiums are based on both the risk associated with the insured and the amount of coverage desired.
Premium FAQs
What Does Paying a Premium Mean?
To pay a premium generally means to pay above the going rate for something, because of some perceived added value or due to supply and demand imbalances. To pay a premium may also refer more narrowly to making payments for an insurance policy or options contract.
What Is Another Word for Premium?
Synonyms for “premium” include prize, fee, dividend, or bonus. In insurance and options trading, it can be synonymous with “price.”
What Are Premium Pricing Examples?
Premium pricing is a marketing strategy that involves setting the price of a particular product higher than a more basic version of that product or versus the competition. The purpose of premium pricing is to convey higher quality or desirability compared to other options.
Related Terms: bond premium, insurance costs, options market, security trading.
References
- Financial Industry Regulatory Authority. “Understanding Bond Yield and Return”.
- U.S. Securities and Exchange Commission. “Investor Bulletin: An Introduction to Options”.
- Merrill. “Options Pricing”.
