In securities markets, a premium is the amount by which a price exceeds a reference value. A bond trades at a premium when its price is above its par value; a takeover bid carries a premium when the offer price is above the target's recent share price; and a closed-end fund or ETF trades at a premium when its price is above its net asset value. The opposite, a price below the reference value, is a discount.
The word has several other financial meanings that should not be confused with these: the price paid for an options contract is called the option premium, an insurance premium is the cost of cover, and the equity risk premium is the extra return investors expect from shares over the risk-free rate. In the UK, "Premium Bonds" are a separate savings product issued by National Savings and Investments since 1956, which pay prizes in a monthly draw instead of interest.
Imagine a concert ticket with "40" printed on it. If the show sells out and a fan pays 60 to get in, they paid a premium of 20 over the printed price. The ticket still gets them the same seat; they paid more because it was worth more to them than its face value.
Investments work the same way. A bond that pays more interest than new bonds on the market is more attractive, so buyers pay above its face value. A company that wants to buy another company outright has to offer shareholders more than today's price to persuade them to sell. In both cases the premium is the extra paid above a reference point.
A bond trades above par when its coupon rate is higher than the yield investors currently demand for similar bonds, usually because interest rates have fallen since it was issued or because the issuer's credit has improved. The price of a bond is the present value of its payments:
- is the price.
- is the annual coupon payment.
- is the market yield, the yield to maturity.
- is the par value repaid at maturity, after years.
Worked example: a five-year bond with a par value of 1,000 pays an annual coupon of 6%, or 60. If similar bonds now yield 5%, its price is about 1,043.29, a premium of about 43.29 or 4.33% of par. The buyer receives more coupon income than on a new 5% bond but gets back only 1,000 at maturity, so the premium shrinks to zero as maturity approaches. Premium bonds are therefore exposed to the same interest rate risk as others, and many corporate bonds trading at a premium are callable, letting the issuer repay them early; investors then look at the "yield to worst" rather than the yield to maturity. When an issuer does call a bond, it often pays a call premium above par as compensation.
In the United States, holders of taxable bonds bought at a premium may elect to amortise the premium over the bond's life under section 171 of the Internal Revenue Code, which reduces taxable interest each year and the bond's cost basis. For tax-exempt municipal bonds the premium must be amortised, but no deduction is allowed. Bonds issued below par carry an "original issue discount" instead.
The most common share-related premium is the takeover or control premium, calculated as:
The unaffected price is the market price before news of the bid leaked. If shares trading at 40 receive an offer of 50, the premium is . Buyers pay it because control lets them change strategy, cut costs or combine operations, and analysts compare it with premiums in similar deals when assessing a company's valuation.
A second meaning appears when shares are first issued. If a company sells shares above their par value, the excess is a share premium, recorded in a share premium account under UK law or as additional paid-in capital in the United States.
Closed-end funds issue a fixed number of shares that trade on an exchange, so their price can drift well above or below the value of the assets they hold; some trade at persistent discounts, others at premiums when their strategy is in demand. An exchange-traded fund usually stays close to its NAV because authorised participants can create or redeem shares and profit from any gap, though premiums and discounts can widen in stressed markets. Under SEC Rule 6c-11, adopted in 2019, most US ETFs must publish information about their premiums and discounts on their websites.
The same idea is applied to prices that differ between markets. The kimchi premium describes bitcoin trading at a higher price on South Korean exchanges than elsewhere, and a parallel-market premium measures how far an unofficial exchange rate sits above the official one, which can be estimated with a black market premium calculator. In each case the premium signals that something, such as capital controls or limited supply, is stopping prices from converging. Credit markets use a related measure, the credit spread, for the extra yield investors demand over government bonds.