Liquidity Premium

What is a Liquidity Premium?

A liquidity premium compensates investors for investing in securities with low liquidity. Liquidity here refers to how easily an investment can be sold for cash. T-billsTreasury Bills (T-Bills)Treasury Bills (T-Bills) are a short-term financial instrument that is issued by the U.S. Treasury with maturity periods ranging from a few days to 52 weeks. They are considered the safest debts since they are backed up by the full faith of the Treasury Department of the United States Government. When an investor buys and stocks are considered to be highly liquid since they can usually be sold at any time. On the other hand, investments such as real estateReal EstateReal estate is real property that consists of land and improvements, which include buildings, fixtures, roads, structures, and utility systems. Property rights give a title of ownership to the land, improvements, and natural resources, such as minerals, plants, animals, water, etc. or debt instruments are to be held for a certain period of time before being sold, making them less liquid.

Why do liquidity premiums exist?

Illiquid investments generally carry more risk than comparatively more liquid investments. It is because holding a single security for a long period of time exposes the investor to several risk factors such as market volatility, a probability of default, economic downturns, interest rate fluctuations, risk-free rateRisk-Free RateA Risk-Free Rate of return is the interest rate an investor can expect to earn on an investment that carries zero risk. In practice, the Risk-Free rate is fluctuations, etc. for a longer period of time. When investors tie up their money in a single security, they also incur the opportunity costOpportunity CostOpportunity cost is one of the key concepts in the study of economics and is prevalent throughout various decision-making processes. Opportunity is the of investing in other assets that may outperform the illiquid investment in the short term. Due to all additional risks, an investor will demand a higher return or a liquidity premium.

Liquidity premiums and bond yields

Going by the idea that illiquid investments represent a greater risk for investors, the liquidity premium is one of the factors that explain differences in bond yields. A bond that matures in many years and that is issued by a little-known company without much financial data for investors to consult may be more difficult to sell. A bond with a shorter maturity issued by the same company would be a comparatively more liquid investment, and thus investors who purchase the bond would require a lower liquidity premium. The concept is illustrated in the graph below:

Here, investors that buy Bond B command a higher return (a liquidity premium) to compensate them for investing in a less liquid investment (relative to Bond A). The example above assumes that all other factors are held constant (i.e., the only difference in the two bonds is their time to maturity).

More resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™FMVA™ CertificationThe Financial Modeling & Valueation Analyst (FMVA)™ accreditation is a global standard for financial analysts that covers finance, accounting, financial modeling, valuation, budgeting, forecasting, presentations, and strategy. certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources:

• Risk-Free RateRisk-Free RateA Risk-Free Rate of return is the interest rate an investor can expect to earn on an investment that carries zero risk. In practice, the Risk-Free rate is
• Default Risk PremiumDefault Risk PremiumA default risk premium is effectively the difference between a debt instrument's interest rate and the risk-free rate. The default risk premium exists to
• Convertible BondConvertible BondA convertible bond is a type of debt security that provides an investor with a right or an obligation to exchange the bond for a predetermined number of shares in the issuing company at certain times of a bond’s lifetime. A convertible bond is a hybrid security that possesses the features of both debt and
• Equity Risk PremiumEquity Risk PremiumEquity risk premium is the difference between returns on equity/individual stock and the risk-free rate of return. It is the compensation to the investor for taking a higher level of risk and investing in equity rather than risk-free securities.