Premiums and Discounts

What Is Premiums and Discounts?

In finance, premiums and discounts refer to the difference between an asset's market price and its intrinsic value or a specific benchmark price. A premium occurs when an asset trades above its underlying value or a reference price, while a discount occurs when it trades below this value. These concepts are fundamental to understanding market pricing and valuation across various financial instruments and are a core component of Market Pricing. The market price of an asset is determined by supply and demand, and it may not always perfectly align with its calculated intrinsic value or net asset value.

History and Origin

The concepts of premiums and discounts have been inherent in financial markets for centuries, dating back to the trading of early financial instruments like bonds. For example, bonds were historically issued at or below their par value, with their market price fluctuating based on prevailing interest rates and the bond's coupon rate. If a bond's fixed interest payments became more attractive than new bonds issued at higher rates, its market price would rise above its face value, trading at a premium. Conversely, if new bonds offered higher rates, an existing bond with a lower coupon would trade at a discount to its par value to compensate for the lower income stream.

In more modern times, the phenomenon of premiums and discounts became particularly pronounced and studied with the advent of investment vehicles like closed-end funds and the pricing of initial public offerings (IPOs). The initial public offering process often sees shares "underpriced" by investment bankers, meaning they are offered at a discount to what the market is willing to pay, typically resulting in a first-day pop or premium in the aftermarket. This practice, often referred to as IPO underpricing, has been a subject of academic research, with studies exploring why IPOs are consistently underpriced, potentially to stimulate demand or reward initial investors.⁹

Key Takeaways

• A premium exists when an asset's market price is higher than its intrinsic value or a benchmark.
• A discount exists when an asset's market price is lower than its intrinsic value or a benchmark.
• These concepts apply across various financial instruments, including bonds, options, and closed-end funds.
• Premiums and discounts are influenced by market sentiment, supply and demand, and specific characteristics of the asset.
• Understanding these differences is crucial for valuation and investment decision-making.

Formula and Calculation

The calculation of a premium or discount is straightforward, representing the percentage difference between the market price and a reference value.

For a closed-end fund (CEF), the reference value is typically its Net asset value (NAV).

• If the result is positive, the fund is trading at a premium.
• If the result is negative, the fund is trading at a discount.

For a bond, the reference value is often its Par value.

Interpreting Premiums and Discounts

Interpreting premiums and discounts requires context. A premium suggests that investors are willing to pay more than an asset's underlying worth, which could indicate strong demand, positive market sentiment, or expectations of future growth. Conversely, a discount might suggest that the market views an asset as undervalued, perhaps due to negative sentiment, perceived risks, or a lack of liquidity.

For Closed-end funds, for instance, trading at a discount to their NAV is common. This can be influenced by factors such as the fund's distribution rate, overall market volatility, or investor sentiment.⁸ While buying at a discount might seem advantageous, a fund trading at a persistent discount may continue to do so, and there is no guarantee that the discount will narrow.⁷ Investors often look at historical premium/discount ranges or utilize metrics like the z-statistic to gauge whether a fund is currently trading at a relative premium or discount compared to its own history.⁶

Hypothetical Example

Consider a hypothetical Closed-end fund, Diversify Global Equity Fund (DGEF).

1. Determine the Net Asset Value (NAV): Suppose DGEF holds a portfolio of stocks and bonds. If the total value of these assets (minus liabilities) is $100 million, and there are 10 million shares outstanding, then the NAV per share is $10.00.
2. Observe the Market Price: On a given day, shares of DGEF trade on an exchange, and the Market price per share closes at $9.50.
3. Calculate the Premium or Discount: $$\text{Premium/Discount (\%)} = \left( \frac{\$9.50 - \$10.00}{\$10.00} \right) \times 100\% = \left( \frac{-\$0.50}{\$10.00} \right) \times 100\% = -5\%$$ In this scenario, DGEF is trading at a 5% discount to its NAV. This means an investor can effectively buy $10.00 worth of assets for $9.50.

Now, imagine DGEF's shares instead trade at $10.75.

Here, DGEF is trading at a 7.5% premium to its NAV, indicating that investors are paying $10.75 for $10.00 worth of underlying assets.

Practical Applications

Premiums and discounts are pervasive in financial markets and critical for various investment decisions:

• Bonds: Bonds are routinely bought and sold at a premium or discount to their Par value, depending on current interest rates relative to the bond's coupon rate and its remaining time to maturity. A bond trading at a premium has a coupon rate higher than current market rates, while a bond trading at a discount has a coupon rate lower than current market rates.⁵
• Closed-End Funds (CEFs): As illustrated, CEFs frequently trade at a premium or discount to their Net asset value. Investors often look for CEFs trading at a discount, hoping for capital appreciation if the discount narrows.⁴
• Options and Futures: The concept also applies to derivative instruments like Options and Futures contracts. An option's premium is the price paid for the contract itself, representing the value of the right, but not the obligation, to buy or sell an underlying asset. Futures contracts can trade at a premium (contango) or discount (backwardation) to the spot price, reflecting market expectations and storage costs.
• Initial Public Offerings (IPOs): During an Initial public offering, shares are often deliberately "underpriced" by the Underwriting syndicate. This creates an immediate premium (the "IPO pop") when shares begin trading on the secondary market, ensuring strong investor demand and a successful launch.³

Limitations and Criticisms

While premiums and discounts offer valuable insights into market dynamics, they have limitations and criticisms. A significant premium or discount does not inherently guarantee future price movement or imply mispricing. For instance, a persistent discount in a Closed-end funds might accurately reflect long-term investor skepticism about the fund's management, investment strategy, or asset liquidity, rather than an Arbitrage opportunity.

Moreover, premiums and discounts can be heavily influenced by market sentiment, which may not always align with fundamental value. An asset could trade at a substantial premium simply due to speculative fervor or "hot money" chasing perceived trends, leading to an inflated Market price unrelated to its Intrinsic value. Conversely, a discount might deepen during periods of panic selling, even for fundamentally sound assets. Investing solely based on a discount, particularly in CEFs, without considering the reasons behind it or its historical context, can lead to unfavorable outcomes if the discount never narrows or even widens.² The volatility of these premiums and discounts can be extreme, especially for certain types of funds.¹

Premiums and Discounts vs. Bid-Ask Spread

While both premiums/discounts and the Bid-ask spread involve price differences in financial markets, they represent distinct concepts.

Premiums and discounts are a gauge of how the market values an asset against a theoretical or fundamental baseline. For example, in Mergers and acquisitions, an acquiring company typically offers a premium over the target company's current share price to incentivize shareholders to sell. The Bid-ask spread, on the other hand, is a real-time reflection of liquidity and transactional friction in the market for an asset at a specific moment.

FAQs

What causes a premium or discount?

Premiums and discounts are influenced by numerous factors, including supply and demand, investor sentiment, fund management performance, perceived risks, distribution policies, and overall market conditions. For example, strong investor demand for an asset might drive its market price above its intrinsic value, creating a premium. Conversely, low demand or concerns about future performance can lead to a discount.

Are premiums always bad and discounts always good?

Not necessarily. While buying at a discount seems like a good deal (getting assets for less than their theoretical value), a discount can persist or even widen if the underlying issues causing it are not resolved. Similarly, a premium might be justified by unique characteristics or strong growth prospects of an asset. The context and reasons behind the premium or discount are more important than the absolute value.

Do all financial instruments have premiums and discounts?

The concepts of premiums and discounts are broadly applicable but manifest differently across various financial instruments. They are most commonly discussed in relation to Closed-end funds (relative to their net asset value), Bonds (relative to their par value), and in the pricing of derivatives like Warrants or Options. In equity markets, the market price of a stock relative to its fundamental or Intrinsic value can also be seen through the lens of premiums and discounts.

How do I use premiums and discounts in my investment decisions?

When considering an investment that trades at a premium or discount, it's essential to research the underlying reasons. For example, for a closed-end fund, analyze its historical premium/discount patterns, management quality, and investment strategy. For bonds, understand how changes in interest rates impact the premium or discount and the bond's Yield to maturity. A premium or discount should be one of many factors considered as part of a comprehensive valuation process, not the sole determinant.