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| What Is a Finance Premium |
What Exactly Is a Premium?
In finance, premium has several meanings. It most commonly refers to:
- A security that trades above its intrinsic or theoretical value is said to be trading at a premium (in contrast to a discount). If the price paid for a fixed-income security is greater than par, the difference between the price paid and the face amount at issue is referred to as a premium.
- The cost of an insurance policy or the regular payments required by an insurer to provide coverage for a specified time period.
- The total cost of purchasing an option contract (often synonymous with its market price).
Recognizing a Premium
A premium, in general, is a price paid above and beyond some basic or intrinsic value. Similarly, it is the cost of protecting oneself from a loss, hazard, or harm (e.g., insurance or options contracts). The term "premium" comes from the Latin praemium, which means "reward" or "prize."
Premium Varieties
Price Increase
A premium is a price that exists above some sort of fundamental value, and such assets or objects are said to trade at a premium. Assets may trade at a premium due to increased demand, limited supply, or expectations of future appreciation.
A premium bond is one that trades above its face value, or one that costs more than the bond's face value. A bond may trade at a premium because its interest rate is higher than market rates.
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 the bond's coupon rate is lower than the then-current interest rate. As a result, the investor pays a premium for an investment that will return more than the current interest rate.
A risk premium refers to expected returns on an asset that are higher than the risk-free rate of return. The risk premium on an asset is a form of compensation for investors. It compensates investors for tolerating the additional risk in a given investment over that of a risk-free asset.
Similarly, the equity risk premium is the excess return provided by investing in the stock market over the risk-free rate. This excess return compensates investors for the higher risk associated with equity investing. The size of the premium varies and is determined by the level of risk in a given portfolio. It also varies over time as market risk varies.
Options Premium
Option premiums are the cost of purchasing an option. The holder (owner) of an option has the right, but not the obligation, to buy or sell the underlying financial instrument at a specified strike price. A bond's premium reflects changes in interest rates or risk profile since the bond's issuance date. An option buyer has the right, but not the obligation, to buy (call) or sell (put) the underlying instrument at a specified strike price for a specified period of time.
The premium paid is equal to the intrinsic value plus the time value; a longer maturity option always costs more than a shorter maturity structure.
The premium is also affected by market volatility and how close the strike price is to the then-current market price.
Sophisticated investors may sell one option (also known as writing an option) and use the premium received to pay for the underlying instrument or another option. Depending on how the position is structured, purchasing multiple options can either increase or decrease the risk profile.
Insurance Coverage
Insurance premiums include the compensation paid to the insurer for bearing the risk of a payout if an event that triggers coverage occurs. A sales agent's or broker's commissions may also be included in the premium. Auto, health, and homeowners insurance are the most common types of coverage.
Insurance premiums are paid for a variety of reasons, including health, homeowners, and rental insurance. Auto insurance is a common example of an insurance premium. A vehicle owner can insure their vehicle's value against loss due to an accident, theft, fire, or other potential problems.
In exchange for the insurance company's guarantee to cover any economic losses incurred under the terms of the agreement, the owner typically pays a fixed premium amount. Premiums are determined by the insured's risk as well as the amount of coverage desired.
Premium Frequently Asked Questions
What Does It Mean to Pay a Premium?
Paying a premium generally means paying more than the going rate for something, either because of perceived added value or due to supply and demand imbalances. Paying a premium can also refer to making payments for an insurance policy or options contract.
What Is a Different Word for Premium?
Prize, fee, dividend, and bonus are all synonyms for "premium." It may be synonymous with "price" in insurance and options trading.
What Are Some Examples of Premium Pricing?
Premium pricing is a marketing strategy that involves strategically raising the price of a specific product above the price of a more basic version of that product or the price of the competition. The goal of premium pricing is to convey greater quality or desirability than alternative options.
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