What is Premium in Finance, Types of Premium and Premium FAQs

Anbarasan Appavu
There are several definitions  and meanings of premium in finance. Typically, it refers to:

1. In general, 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 exceeds par, the difference between that price and the security's face amount at issue is referred to as a premium.

2. The price of an insurance policy or the periodic payments required by an insurer to provide coverage for a specified time period.

3. The overall price to acquire an option contract (often synonymous with its market price).

Premium in Finance Definition

• Premium can refer to a variety of financial concepts, including the cost of purchasing an insurance policy or an option.

• Premium is also the price of a bond or other security that exceeds the price at which it was issued or its intrinsic value.

• A bond may trade at a premium if its interest rate exceeds the current market rate.

People may pay a premium for certain items that are in high demand.

• Something that trades at a premium may also be overpriced.

Understanding About Premium

In general, a premium is a price paid above and beyond some intrinsic or basic value. Similarly, it is the cost of protection against loss, risk, or harm (e.g., insurance or options contracts). The term "premium" comes originally from the Latin word praemium, which is meant as "prize" or "reward".

Types of Premium

Price Premium

A premium is a price that exists above some sort of fundamental value, and assets or objects that trade at a premium are said to be trading at a premium. Assets may trade at a premium as a result of increased demand, limited supply, or expectations of future appreciation in value.

A premium bond is a bond that trades above its face value, or one that costs more than the bond's face value. A bond may trade at a premium if its interest rate is greater than the current market rate.

The concept of a bond price premium is always related to the principle that the bond price is inversely interrelated to interest rates. Say if a fixed-income security is purchased at a premium, this indicates that current interest rates are lower than the bond's coupon rate. Thus, the investor pays a premium for an investment that will yield a greater return than current interest rates.

A risk premium involves the expected returns on an asset that exceeds the risk-free rate of return. Often the risk premium of an asset is the form of compensation to the investors. It represents the compensation investors receive for accepting greater risk in a given investment compared to a risk-free asset.

Likewise, the equity risk premium refers to the excess return that investing in the stock market offers over a risk-free rate. This excess return will compensate the investors for relatively greater risk associated with equity investments. The size of the premium varies and is dependent on the portfolio's risk level. Additionally, it fluctuates over time as market risk changes.

Options Premium

Options premiums represent the cost to purchase an option. Options confer the right, but not the obligation, to buy or sell the underlying financial instrument at the strike price. A bond's premium reflects changes in interest rates or risk profile since the date of issuance. The buyer of an option has the right, but not the obligation, to buy (call) or sell (put) the underlying asset at a specified strike price for a specified time period.

The premium is equal to the intrinsic value plus the time value, an option with a longer maturity always costs more than one with a shorter maturity for the same structure. In addition to market volatility and strike price proximity, market volatility and strike price proximity also influence the premium.

Sometimes, sophisticated investors will sell an option (also known as writing an option) and use the premium received to pay for the purchase of the underlying instrument or another option. Depending on how the purchase of multiple options is structured, the risk profile of the position can either increase or decrease.

Insurance Premium

Insurance premiums include payment to the insurer for bearing the risk of a payout should an event that triggers coverage occur. The premium may also include commissions for the sales agent or broker. The most prevalent types of insurance are auto, health, and homeowners.

Numerous types of insurance, including health, homeowner's, and rental, require premium payments. Auto insurance provides a typical illustration of an insurance premium. The owner of a vehicle can insure its value against loss due to accident, theft, fire, and other potential problems.

In exchange for the insurance company's promise to cover any economic losses incurred within the scope of the agreement, the owner typically pays a fixed premium. The risk associated with the insured and the desired level of coverage determine the premiums.

Premium FAQs

What Does It Mean to Pay a Premium?

In general, to pay a premium is to pay more than the going rate for something because of perceived added value or supply and demand imbalances. To pay a premium may also refer to paying for an insurance policy or an options contract.

What Is a Synonym for Premium?

Premium is synonymous with prize, fee, dividend, and bonus. 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 entails tactically pricing a product higher than either a more basic version of that product or the competition. The objective of premium pricing is to convey superior quality or desirability compared to other alternatives.

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