Discounts, Premiums, and Arbitrages

Discounts and Premium

When there is a price discrepancy between a security’s underlying value (like Net Asset Value) and the market price it is being traded at, it becomes a Discount/Premium security. So when it’s a Discount, the security is being traded below its NAV. Conversely, premiums are when a security is traded below its NAV.

If you’re still confused, think of how some securities are like investment vehicles. They hold a portfolio of assets where you can see individual investment prices and where they regularly report its NAV. Since it’s a vehicle that is “separate” from the portfolio, its price can be traded lower or above its true value (NAV). Here is a list of some securities that can have discounts or premiums:

• Exchange-Traded Funds (ETFs)

• Closed-End Funds (CEFs)

• Real Estate Investment Trusts (REITs)

How Do They Form?

They can form in many ways, as long as it meets the criteria of Market Value ≠ Underlying Value, it results in a discount or premium. However, there are four categories I can sort of put into how they form: Fundamental, Structural, Behavioral, and Technical. It’s more like categories to scenarios as to why discounts and premiums can form, since those terms aren’t actually labeled onto securities.

Fundamental

It’s the market reaction to a holding company’s financial statements or financial history. For example:

When a holding company of a security has added risk or a history of low cash flows, investors want to be compensated for this added risk. To ensure it sells, trading at a discount is important to offset those downsides. The opposite is true; when the holding company has great cash flows and lower risk, investors are willing to pay a premium for it, as they are confident in the security’s performance.

It’s more about how investors feel about the security they want to buy/sell. If they’re optimistic or pessimistic.

Companies set their IPO lower than what they assume it’d be worth to incentivize hype. Based on market reactions, it can go higher, which is selling at a premium than what the IPO initially listed. Conversely, if the investors react negatively to bad news of the company, it will sell at a discount due to this immediate reaction.

What we should take away from this is that price discrepancy is caused by varying factors that can or cannot be predicted. Sometimes they’re obvious inefficiencies, but other times it can be just pure optimism.

Arbitrage

The definition of an arbitrage is the simultaneous purchase and sale of securities or foreign exchange in different markets to profit from price discrepancies. When a market is inefficient from Time Zones or from Market Reactions, there will be traders ready to capitalize on it.

The Principle of Market Efficiency is that the market price for a security will be equal across the differing markets. Traders who make money off an arbitrage actually reinforce the principle, as when they buy low and sell high, they’re not only keeping it liquid, but also forcing the prices to align with fair market value. Traders call the profit “risk free”, but in reality the upfront costs can be very high.

This might sound easy, but the timing window is extremely small and comes far and few between. Any time delays can cost significant loss or failed opportunity. Investopedia dives deeper into it, which you should check it out here: What is Arbitrage. I might cover this in the future, and if I do I’ll link my blog to it.

Efficient Hypothesis Market (EHM)

While researching, I’ve found this interesting hypothesis. This isn’t major to the overall blog, so you can skip this if you want.

EHM states that “share prices reflect all available information and consistent alpha generation is impossible” (Downey 1). This implies that the concept of Arbitrage shouldn’t exist, or realistically will eventually stop existing because it takes advantage of market inefficiencies. Believers say that in order to make profit it has to be high-risk to receive high reward, or long-term investing to ensure growth. EHM argues that it’s pointless to search for undervalued stocks or use prediction patterns/models to turn a profit, as you will never outperform the market.

One problem arose, it’s impossible for a perfectly efficient market to occur, since it states that all information, whether public or private, is reflected on the stock’s price. Warren Buffet has taken advantage of market inefficiencies to become the billionaire he is today.

The hypothesis makes sense in a perfect world, but just doesn’t work in reality. Arbitrage is important to help achieve efficiency, but it will never achieve max efficiency.

The Bottom Line

When you’re actively investing, it’s important to understand why you can purchase securities at a discount or premium. You can even take a step further by arbitraging the investments, making lots of money. Although it’s not an easy task that any investors can do and requires a lot of skill and practice in order to perfectly execute these trades.

For more passive investors, this topic is great to know when you’re trying to purchase a security that is undervalued from its true value. Whether it’s behavioral or technical, you can always take advantage of it and have greater total returns. Just be sure that the history of the security isn’t constantly fluctuating and do proper research to gauge its volatility.

Just a reminder that this isn’t investment or financial advice. I’m learning this with everyone else, just taking my time to combine all the topics together. Just be prepared when I cover Orders and Options as it links really well with Discounts and Premiums!

SOURCES

Downey, L. November 15, 2025. Efficient Market Hypothesis (EMH): Definition and Critique. Investopedia. https://www.investopedia.com/terms/e/efficientmarkethypothesis.asp

Thompson, C. April 22, 2025. What is Arbitrage? Definition, Example, and Costs. Investopedia. https://www.investopedia.com/ask/answers/what-is-arbitrage/

(Retrieved April 30, 2026). Understanding premiums and discounts for ETFs. Fidelity Learn. https://www.fidelity.com/learning-center/investment-products/etf/premiums-discounts-etfs