Liquidity Premium

What Is a Liquidity Premium?

A liquidity premium is any form of extra compensation that is required to empower investment in assets that won't be quickly and productively changed over into cash at fair market value.

For instance, a long-term bond will carry a higher interest rate than a short-term bond since it is relatively illiquid. The higher return is the liquidity premium offered to the investor as compensation for the extra risk.

Figuring out the Liquidity Premium

Investors in illiquid assets require compensation for the additional risk of investing their money in assets that will be unable to be sold for an extended period, particularly in the event that their values can change with the markets in the interim.

Liquid investments are assets that can be effectively and immediately changed over into cash at their fair market value. A savings account or a short-term Treasury bond are models. The returns might be low, however the money is safe and can be gotten to whenever for its fair value. Many bonds are relatively liquid, as they are effectively convertible or might be sold on an active secondary market.

Illiquid investments have the contrary qualities. They won't be quickly sold at their fair market value.

Illiquidity is viewed as a form of risk. The investor's money is tied up.

Liquid and Illiquid Investments

Illiquid investments can take many forms. These investments incorporate certificates of deposit (CDs), certain loans, annuities, and other investment assets that the purchaser is required to hold for a predefined period of time. The investments can't be liquidated or removed right on time without a penalty.

Different assets are considered illiquid in light of the fact that they have no active secondary market that can be utilized to understand their fair market value.

The liquidity premium is incorporated into the return on these types of investments to make up for the risk the investor takes in securing funds for a long period of time.

As a general rule, investors who decide to invest in such illiquid investments should be compensated for the additional risks that a lack of liquidity presents. Investors who have the capital to invest in longer-term investments can benefit from the liquidity premium earned from these investments.

The terms illiquidity premium and liquidity premium are utilized reciprocally. Both mean that an investor is getting an incentive for a longer-term investment.

Instances of Liquidity Premiums

The state of the yield curve can additionally illustrate the liquidity premium demanded from investors for longer-term investments. In a balanced economic environment, longer-term investments require a higher rate of return than shorter-term investments — consequently, the vertical slanting state of the yield curve.

As another model, expect an investor is hoping to purchase one of two corporate bonds that have the equivalent coupon payments and time to maturity. Taking into account one of these bonds is traded on a public exchange while the other isn't, the investor isn't willing to pay as much for the nonpublic bond. This means a higher premium at maturity. The difference in the relative prices and yields is the liquidity premium.

Features

• Illiquidity is viewed as a form of investment risk. In any event it very well may be an opportunity risk on the off chance that better investments arise while the money is tied up.
• The more illiquid the investment, the greater the liquidity premium that will be required.
• The liquidity premium is a form of extra compensation that is incorporated into the return of an asset that can't be cashed in effectively or rapidly.