Discount and Premium

The market price at which the shares of a closed-end fund are traded may be at a discount or premium to the net asset value (NAV) of the fund. As mentioned earlier, net asset value is the value of the underlying stocks and bonds in the fund. So if the market price of the CEF is above the NAV of the fund, then the CEF is trading at a premium. In the opposite case, that is when the market price is lower than the NAV, the CEF is trading at a discount. The rate of the premium/discount can be computed using the following formula:

Premium/Discount=(MP-NAV)/NAV

where, MP is Market Price

The discounts and premiums are what makes investing in CEF's rewarding. The rewards depend on whether the fund is trading at a discount or a premium to the NAV. Such profitability comes in many forms and some of them are in the form of Magnified Yields and Shrinking Discounts.

Magnified Yields: When CEF's trade at a discount, purchasing them would offer higher yields because dividends are calculated on the NAV while the fund is being purchased at the discounted market value.

Example: The market value of a CEF is $10 when the NAV of the fund is $12, therefore the CEF being traded at a discount of 20% . Suppose the dividend yield is 10% which is $1.20 since dividend is calculated on the NAV. The investor has only spent $10 in purchasing the fund so his yield is higher than 10%, which is 12%.

Shrinking Discounts: An investor might make significant profits from shrinking discounts. In such situations a fund that had been purchases by an investor, for example, may experience significant growth in NAV for reasons such as good market conditions. This may attract more investors and as the demand for the fund goes up, it may push the market value up such that the fund starts being traded at a premium. In that case, the investor who had originally purchased the fund at a discount may sell his share at the prevailing premium market value and therefore reap considerable profits.

Example: A CEF with NAV $12 and trading at a discount of $10 experiences an NAV growth to $20 due to good market conditions thereby attracting more investors. As demand goes up, the market value increases to $20. At this point the investor who originally purchased the share of the CEF at the discounted value sells his share at the new premium market price thereby making 100% profit since now the market value has doubled.

Above were just two situations describing ways in which discounts/premiums allow investors to make profits. There are other advantages that allow for profitability such as the leverage potential of the fund.