What is a Liquidity Premium?
A liquidity premium compensates investors for investing in securities with low liquidity. Liquidity refers to how easily an investment can be sold for cash. T-billsTreasury Bills (T-Bills)Treasury Bills (or T-Bills for short) are a short-term financial instrument that is issued by the US Treasury with maturity periods ranging from a few days up to 52 weeks (one year). They are considered among the safest investments since they are backed by the full faith and credit of the United States Government. and stocks are considered to be highly liquid since they can usually be sold at any time at the prevailing market price. 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 or debt instruments are less liquid. It may take quite some time to sell real estate at the desired price. Some debt instruments must be held for a certain period of time before being sold.
Why do liquidity premiums exist?
Illiquid investments carry more risk than comparatively more liquid investments. This is because holding a single security for a long period of time exposes the investor to several risk factors, such as market volatility, potential default, economic downturns, interest rate fluctuations, risk-free rateRisk-Free RateThe 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 commonly considered to equal to the interest paid on 3-month government Treasury bill, generally the safest investment an investor can make. fluctuations, etc. 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. The opportunity cost is the value of the next best alternative foregone. of investing in other assets that may outperform the illiquid investment. Due to the additional risks, an investor will demand a higher return, known as 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. 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. The example above assumes that all other factors are held constant (i.e., the only difference is time to maturity).
More resources
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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 RateThe 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 commonly considered to equal to the interest paid on 3-month government Treasury bill, generally the safest investment an investor can make.
- 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 compensate investors for an entity's likelihood of defaulting on their debt.
- 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
- 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.
