In finance, premium can mean different things. It most frequently refers to:
- Generally speaking, a security trading at a premium is one that is above its theoretical or intrinsic value (in contrast to a discount). If the price paid for a fixed-income security is higher than par, the difference between that price and the security’s face amount is referred to as a premium.
- The price of purchasing an insurance policy or the regular payments that an insurer requires to offer coverage for a specific amount of time.
- The full cost to buy an option contract (often synonymous with its market price).
KEY LESSONS
- In the world of finance, “premium” can buy to a variety of things, such as the cost of purchasing an insurance policy or an option.
- A bond’s or other security’s premium price is the amount paid over the issuance price or intrinsic value of the security.
- Because its interest rate is higher than the interest rates on the market right now, a bond might trade at a premium.
- For certain items that are in high demand, people might pay more.
- Trading at a premium may also be a sign that something is overpriced.
- Recognizing a Premium
- In general, a premium is a price that is paid above and beyond some fundamental or intrinsic value. Relatedly, it is the price paid with being shielded from a loss, risk, or injury (e.g., insurance or options contracts). Premium is a derivative of the Latin word praemium, which originally meant “reward” or “prize.”
Types of premium
Premium price
Such assets or objects are said to be trading at a premium if their price is higher than some sort of fundamental value. Due to rising demand, tight supply, or expectations of rising value in the future, assets may trade at a premium.
A bond that trades above its face value, or in other words, one that costs more than the bond’s face value, is referred to as a premium bond. Because its interest rate is higher than the market’s current rates, a bond may trade at a premium.
The price of a bond price premium stems from the idea that bond prices are inversely correlated with interest rates; if a fixed-income security is bought at a premium, it means that the going interest rates are lower than the bond’s coupon rate. In this way, the investor pays a premium for an investment that will return returns that are higher than current interest rates.
Returns on an asset are anticipated to be higher than the risk-free rate of return when there is a risk premium. Investors receive compensation in the form of an asset’s risk premium. It serves as compensation to investors for their willingness to accept greater risk in a particular investment than in a risk-free asset.
Similar to this, an excess return provided by stock market investment over a risk-free rate is referred to as the equity risk premium. Investors receive compensation from this excess return for accepting the comparatively higher risk of equity investing. The premium’s size varies and is influenced by the amount of risk in a given portfolio. Additionally, it evolves with time as market risk changes.
Premium Options
The price to purchase an option is its premium. Options grant the holder (owner) the right, but not the obligation, to buy or sell the underlying financial instrument at a designated strike price. Since the bond’s issuance, interest rates and risk factors have changed, which is reflected in the premium. An option’s buyer is granted the right, but not the obligation, to buy (call) or sell (put) the underlying asset at a specified strike price for a specified amount of time.
An option with a longer maturity always costs more than a similar structure with a shorter maturity; the premium paid is its intrinsic value plus its time value. The premium is also influenced by the market’s volatility and how closely the strike price tracks the then-current market price.
Sometimes knowledgeable investors will sell one option (also referred to as writing an option) and use the proceeds to cover for the premium of the underlying cost or another option. Depending on how the position is set up, purchasing multiple options can either raise or lower the risk profile of the investment.
Insurance premium
The compensation the insurer receives for assuming the risk of a payout should an event occur that triggers coverage is included in insurance premiums. The commissions earned by a sales agent or broker may also be included in the premium. Auto, health, and homeowner’s insurance are the three most popular types of coverage.
Numerous insurance policies require payment of premiums, including health, homeowner’s, and rental insurance. Auto insurance premiums are a typical illustration of an insurance premium. A vehicle owner can purchase insurance to protect the value of their vehicle from loss due to an accident, theft, fire, or other potential issues.
In exchange for the insurance company’s promise to cover for any financial losses incurred within the parameters of the agreement, the owner typically pays a set premium amount. The risk posed by the insured and the desired level of coverage are taken into account when calculating premiums.
Premium FAQs
How Do Premium Payments Work?
Paying a premium typically refers to paying more than the market price for something due to a perceived added value or an imbalance in supply and demand. A more specific definition of paying a premium would be paying for an insurance policy or options contract.
What Languages Use Premium?
Premium can be replaced with a prize, fee, dividend, or bonus. It might be synonymous to “price” in the trading of options and insurance.
What Are Some Examples of Premium Pricing?
A tactical price increase of a specific product’s price over either a more basic version of that product or the competition is known as premium pricing in marketing. Premium pricing is used to suggest higher quality or desirability than competing options.
