What is a Liquidity Premium?

A liquidity premium compensates investors for investing in securities with low liquidity. Liquidity describes how easily an investment can be sold for cash. T-billsTreasury receipt (T-Bills)Treasury receipt (or T-Bills for short) are a momentary financial instrument issued by the us Treasury v maturity periods from a couple of days up to 52 weeks. And also stocks are taken into consideration to be extremely liquid due to the fact that they can usually be marketed at any kind of time at the prevailing market price. Top top the various other hand, investments such as genuine estateReal EstateReal legacy is real residential property that is composed of land and also improvements, which include buildings, fixtures, roads, structures, and utility systems. Residential property rights provide a title of ownership to the land, improvements, and natural sources such together minerals, plants, animals, water, etc. Or debt tools are much less liquid. It might take fairly some time to sell genuine estate in ~ the preferred price. Part debt tools must be held for a certain duration of time prior to being sold.

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Why do liquidity premiums exist?

Illiquid investments carry more risk 보다 comparatively an ext liquid investments. This is since holding a single security because that a long duration of time exposes the investors to several risk factors, together 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 invest that dead zero risk. In practice, the risk-free rate is typically considered to same to the attention paid on a 3-month government Treasury bill, usually the safest investment an investor have the right to make. Fluctuations, etc. When investors tie up their money in a solitary security, they likewise incur the possibility costOpportunity CostOpportunity price is one of the vital concepts in the research of economics and is common throughout assorted decision-making processes. The that investing in various other assets that might outperform the illiquid investment. Due to the added risks, an investor will demand a greater return, recognized as a liquidity premium.

Liquidity premiums and bond yields

Going by the idea that illiquid investments represent a higher risk because that investors, the liquidity premium is among the factors that explain differences in shortcut yields. A bond that matures in numerous years and that is issued by a little-known agency without much financial data for investors to consult might be more difficult to sell. A bond with a much shorter maturity authorize by the same company would be a comparatively more liquid investment. Thus, investor who purchase that bond would need a lower liquidity premium. The principle is depicted in the graph below:

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Here, investors that buy link B command a greater return (a liquidity premium) come compensate them for investing in a less liquid investment. The example over assumes that all other components are held constant (i.e., the only difference is time to maturity).

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