The liquidity premium is a premium demanded by investors when a given security cannot be easily converted into cash at its fair market value. When the liquidity premium is high, the asset is said to be illiquid and investors demand additional compensation for the additional risk of investing their assets over a longer period, as valuations may fluctuate depending on market effects.
Break down the liquidity premium
Liquid investments are assets that can be easily converted to cash at fair market value. The investment conditions may allow easy convertibility, or there may be an active secondary market for which the investment can be negotiated. Illiquid investments in the market are the opposite of liquid investments because they cannot be easily converted into cash at fair market value. Illiquid investments can take many forms. These investments include certificates of deposit (CDs), loans, real estate and other investment assets in which the investor is required to remain invested for a specified period. These investments cannot be liquidated, withdrawn without penalty or actively traded on a secondary market for their fair market value.
Illiquid investments oblige investors to commit over the entire investment period. Investors in these illiquid investments expect a premium, known as a liquidity premium, for the risk of freezing their funds over a given period. Often the terms liquidity premium and liquidity premium can be used interchangeably to mean the same thing. Both terms imply that an investor should receive a premium for a longer term investment.
The shape of the yield curve can further illustrate the liquidity premium required from investors for longer-term investments. In a balanced economic environment, longer-term investments require a higher rate of return than shorter-term investments, hence the upward sloping shape of the yield curve.
In a further example, suppose an investor is looking to buy one of two corporate bonds that have the same coupon payments and the same maturity. Since one of these bonds is traded on a public exchange while the other is not, the investor is unwilling to pay as much for the non-public bond, thereby receiving a higher premium. at the due date. The difference in price and yield is the liquidity premium.
Overall, investors who choose to invest in longer-term illiquid investments want to be rewarded for the additional risks. In addition, investors who have the capital to invest in longer-term investments can benefit from the liquidity premium generated by these investments.