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What Is a Premium?
You know, a premium represents the price you pay for a good or service that's above and beyond the item's intrinsic value. In finance, premium has several meanings, but most commonly, it refers to a security trading above its intrinsic or theoretical value—that's trading at a premium, as opposed to a discount. For fixed-income securities, the premium is the difference between the price you pay and the security's face amount at issue, if that price is higher than par. It also means the purchase price of an insurance policy or the regular payments you make to an insurer for coverage over a defined period. And don't forget, it's the total cost to buy an option contract, often just 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.
Understanding a Premium
Broadly speaking, I'm telling you that a premium is a price you pay above and beyond some basic or intrinsic value. It's also the price you pay for protection from a loss, hazard, or harm, like in insurance or options contracts. The word 'premium' comes from the Latin praemium, meaning 'reward' or 'prize'—that makes sense when you think about it.
Types of Premium
Let's break down the types. First, there's the price premium: that's a price above some fundamental value, and assets or objects trading like that are said to be at a premium. This happens due to increased demand, limited supply, or expectations of higher value in the future.
A premium bond is one trading above its face value; it costs more than the face amount. This often occurs because its interest rate is higher than current market rates. The bond price premium ties into the idea that bond prices are inversely related to interest rates. If you buy a fixed-income security at a premium, it means current interest rates are lower than the bond's coupon rate, so you're paying extra for an investment that returns more than existing rates.
Then there's the risk premium: that's the return on an asset expected to exceed the risk-free rate. It's compensation for you as an investor tolerating extra risk over a risk-free asset. Similarly, the equity risk premium is the excess return from investing in the stock market over a risk-free rate, compensating for the higher risk of equities. The size of this premium varies with the risk level in a portfolio and changes over time as market risk fluctuates.
For options, the premium is simply the cost to buy an option. Options give you the right, but not the obligation, to buy or sell the underlying instrument at a specified strike price. The premium for a bond reflects changes in interest rates or risk profile since issuance. The premium paid is its intrinsic value plus time value; longer maturities cost more than shorter ones with the same structure. Market volatility and how close the strike is to the current price affect it too. Sophisticated investors might sell an option and use the premium to cover buying the underlying or another option, which can increase or reduce risk depending on the structure.
Finally, insurance premiums are the compensation the insurer gets for bearing the risk of a payout if a covered event happens. These might include commissions for agents or brokers. Common types are auto, health, and homeowners insurance. You pay premiums regularly to keep the policy active. For example, with auto insurance, you insure your vehicle's value against accidents, theft, fire, etc., paying a fixed amount for the insurer's guarantee to cover losses. Premiums are based on the insured's risk and desired coverage amount.
Premium FAQs
What does paying a premium mean? It generally means paying above the going rate for something due to perceived added value or supply-demand imbalances. More narrowly, it refers to payments for an insurance policy or options contract.
What is another word for premium? Synonyms include prize, fee, dividend, or bonus. In insurance and options, it can just mean 'price.'
What are premium pricing examples? Premium pricing is a strategy where you set a product's price higher than a basic version or competitors to convey higher quality or desirability.
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