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-bills 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 estate 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 rate fluctuations, etc. for a longer period of time. When investors tie up their money in a single security, they also incur the opportunity cost 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).
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