Liquidity Premium - Explained
What is a Liquidity Premium?
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Table of ContentsWhat is a Liquidity Premium?How Does a Liquidity Premium Work?Why Liquidity Premiums ExistInvestment CommitmentYield Curve Implications
What is a Liquidity Premium?
Liquidity premium refers to a premium that investors demand when the conversion of security into cash at fair market value becomes difficult. The assets are considered illiquid when there is high liquidity premium. For this reason, investors usually demand extra compensation because of the additional risk involved in investing their assets for a long period. Remember, there is fluctuation in valuations whenever there are market effects, and so, assets under long term investment have a high chance of being affected. In other words, the longer the investment period, the higher the risk.
How Does a Liquidity Premium Work?
The liquid is an easy way of converting assets to cash without making a substantial sacrifice to the market value. A liquid investment is, therefore, assets you can easily convert to cash at a market fair value. Liquidity exists in many forms, including those among the same class of assets. A good example of a liquid investment is publicly traded stocks such as short-term treasuries. They operate on an auction system that is continuous and very liquid. Note that the difference between the price a buyer is ready to pay, and the lowest a seller is willing to receive, can be a cent or two. So, if you wish to sell stocks shares, all you need is to enter an order to sell it at the best price on offer (bid price). By doing so, the execution of trade becomes immediate. The opposite of liquid investment is illiquid investments. With illiquid investments, they take time to convert to cash at their market value. A common example of illiquid investment is real estate. Selling a house at a set market value can take a relatively long time. The time can run from weeks, months, or even more. However, you can be able to sell a house much faster, only if you are willing to sell it below the current market value. It is quite the opposite when it comes to liquidity. There are various forms of illiquid investments. They include certificates, real estate, loans, among other investment assets that should remain in the investment for a specified period of time. You cannot liquidate or withdraw these types of investments. Also, you cannot actively trade them on a secondary market for their fair market value.
Why Liquidity Premiums Exist
There are more risks to illiquid investment than it is with liquid investments. The reason is that single security is held for a long period of time and, therefore, likely to expose investors to more risk factors such as:
- Market volatility
- Economic downturns
- Potential default
- Fluctuation in interest rests
- Fluctuation in free interest rates
So, when investors get their funds tied up in a single security, there is opportunity cost they incur when they don't invest in other assets that are likely to perform better than the illiquid investment. Because of these additional risks that occur in illiquid assets, investors usually demand high returns from such investment as compensation. This is what is called a liquidity premium.
Investors need to have an investment period of commitment when it comes to illiquid investment. They should commit themselves for the entire period of investment. There is what we call illiquidity premium that investors expect as a return for the risk they take to lock up their funds for a specific period of time. Illiquidity premium, therefore, infers to the premium an investor should get for accepting to put their funds in a long term investment.
Yield Curve Implications
The liquidity premium is among the many factors that account for the yield curve. A good example is the upward yield curve, which you can see in different maturities of bond investments across interest rates. The yield curve shape can also illustrate the liquidity premium where investors demand long-term investments. Compared to short term investments, long term investments require a higher rate of return, especially in an environment with a balanced economy. This is what causes the yield curves upward slope. Example Lets assume that an investor plans to purchase one corporate bond, and there are two of them, with the same time of maturity and coupon payments. Lets also assume that the trading of one of the bonds is done on a public exchange, while the second one is not. And the investor is not ready to invest much for the nonpublic bond, a move that enables him to receive a better premium at maturity. So, the difference in yields and premiums is what we call liquidity premium.