What is a Premium?

The term premium in finance is kind of like an all-purpose cleaner…

An all-purpose cleaner has many uses and you can use it to clean a bunch of different spots in your home. Similarly, a premium is a bit of an all-purpose term. It appears in several different places in finance with several different meanings — Often, it refers to the price or value of something.

The term premium is one that can apply to many different areas of finance, from investing to insurance. Let’s talk about a few of the different uses for the term.

An option is a contractual agreement that gives the buyer the right to either buy or sell an underlying security at a particular price (aka the strike price) before a predetermined expiration date.

A put option is one that gives the buyer the right — but not the obligation — to sell a security, while a call option provides the buyer with the right to purchase a security.

A premium when it comes to options is the price of the option, which usually represents 100 shares of the underlying stock.

Several factors go into determining the premium of an option. One of those factors is the price of the underlying security. In the case of a long (buy the call) call option, the premium will increase or decrease as the price of the security increases or decreases. For long put options, the premium will increase or decrease opposite what happens to the price of the security. So when the security’s price goes up, the put option’s premium typically goes down.

Another factor that affects the premium is the volatility of the stock’s price. When a stock’s price is highly volatile, it’s likely that its price will swing significantly in one direction or the other. Low volatility means there will likely be little change.

For both put options and call options, you’re hoping the price of the security will change. Therefore, volatility can be a good thing (if it goes your way), and a more volatile stock is likely to result in a higher option premium.

One more factor that impacts the price of the premium is how far away the expiration date is. The sooner the expiration date, the lower the premium will probably be — This is because there is less time for the stock price to either rise or fall to be “in the money” (profitable).

When an investor buys either a put option or a call option, the premium is nonrefundable regardless of what action they take with the option later. But that doesn’t mean they can’t make their money back.

A premium bond is one that is currently selling for more than its face value. A bond might be trading at a premium if the bond’s interest rate (aka its coupon rate) exceeds the current market rate.

Because traditional bonds are fixed-rate investments, the interest rate doesn’t change over the life of the bond. As a result, it’s possible that a bond’s coupon rate could one day be higher (or lower) than the average market interest rate for those types of bonds.

For example, let’s say you purchased a bond for $500 with a coupon rate of 5%. Since the time you bought the bond, the market interest rate has gone down to 3%. Because that bond gets higher returns than the market, it’s worth more than it was before. Therefore, you could likely sell that bond for a premium above its face value of $500.

It could also work in the other direction. If a bond’s interest rate is lower than the current market rate, then that bond might sell at a discount, meaning for less than its face value.

An insurance premium is a type of premium most people are likely familiar with — It’s the amount of money a policyholder pays an insurance company for insurance coverage.

Premiums usually apply in just about every type of insurance, including health insurance, auto insurance, life insurance, casualty insurance, and umbrella insurance. Depending on the type of insurance contract you have, you’ll likely have different payment options and might pay monthly, biannually, or annually for your policy.

Several different factors go into determining insurance policy premiums. The first factor is the amount of coverage you have. With each type of insurance, you’ll probably have different coverage options from which to choose. The more coverage you buy, the higher your premium will be.

Another determining factor will be how risky a customer you are. Insurance companies look at many risk factors when determining someone’s premium — Their age, their lifestyle, their claims history, etc. Insurance companies will charge a higher premium to customers they deem a higher risk.

It’s also important to note that your premium won’t be the only cost you pay for insurance. You’ll often also have a deductible, which you’ll pay either per claim or per year, depending on the type of insurance. You also may have copays in the case of health insurance, which is a small amount you pay out of pocket each time you use your insurance.

A risk premium is a difference between the risk-free rate of return and the return that an investor requires for the level of risk they took on. In other words, the higher the level of risk associated with a particular investment, the higher the rate of return the investor would expect to get.

The rate of a U.S. Treasury bond usually represents the risk-free rate of return. Because the Treasury Department backs these investments, they are as close to risk-free as you can get. As you venture into riskier investments, you would expect the potential return to increase with the level of risk ⁠— This higher return is the risk premium.

Suppose you’re considering investing in either U.S. Treasury bonds or the stock market. Treasury bonds are a nearly risk-free investment, while the stock market carries an inherent risk. Therefore, you’d expect stock market investments to give a higher return. And looking at data from 2019, it’s clear that was the case. While the Treasury rate at the end of 2019 was 1.92%, the S&P 500 saw a return of 29%.

The formula for a risk premium looks like this:

Market Risk Premium = Expected Rate of Return — Risk-Free Rate of Return

Let’s use that formula to measure the risk premium of investing in the stock market instead of U.S. Treasury bonds in 2019.

By doing the above calculation, we can see that the risk premium of investing in the stock market in 2019 was 27.08%. Here’s what that calculation looks like:

S&P 500 return of 29% — U.S. Treasury rate of 1.92% = 27.08%

Value premium, another term in investing, refers to the theory that value stocks (aka high book-to-market stocks) have higher expected returns than growth stocks (aka low book-to-market stocks). There’s plenty of debate as to whether this is actually the case.

A value stock is one that is trading at a lower price than you would expect when compared to value estimations. Someone buying a value stock would do so with the hope that the market would correct the price — But there’s always the chance that the market won’t correct, which makes these riskier investments.

A growth stock is one that has a strong growth rate and a high return on equity. These stocks trade at a higher price than their valuation indicates but have the potential of being overpriced if their promised growth does not materialize.

Keep in mind options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies carry additional risk. To learn more about the risks associated with options trading, please review the options disclosure document entitled Characteristics and Risks of Standardized Options, available here or through https://www.theocc.com. Investors should consider their investment objectives and risks carefully before trading options. Supporting documentation for any claims, if applicable, will be furnished upon request.