economics Economics () is the social science that studies the production, distribution, and consumption of goods and services. Economics focuses on the behaviour and interactions of economic agents and how economies work. Microeconomics analyzes ...

, a liquidity premium is the explanation for a difference between two types of

financial securities A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any for ...

(e.g. stocks), that have all the same qualities except

liquidity Liquidity is a concept in economics involving the convertibility of assets and obligations. It can include: * Market liquidity, the ease with which an asset can be sold * Accounting liquidity, the ability to meet cash obligations when due * Liq ...

. It is a segment of a three-part

theory A theory is a rational type of abstract thinking about a phenomenon, or the results of such thinking. The process of contemplative and rational thinking is often associated with such processes as observational study or research. Theories may be ...

that works to explain the behavior of

yield curve In finance, the yield curve is a graph which depicts how the yields on debt instruments - such as bonds - vary as a function of their years remaining to maturity. Typically, the graph's horizontal or x-axis is a time line of months or ye ...

s for interest rates. The upwards-curving component of the interest yield can be explained by the liquidity premium. The reason behind this is that short term securities are less risky compared to long term rates due to the difference in maturity dates. Therefore

investor An investor is a person who allocates financial capital with the expectation of a future return (profit) or to gain an advantage (interest). Through this allocated capital most of the time the investor purchases some species of property. Type ...

s expect a premium, or

risk premium A risk premium is a measure of excess return that is required by an individual to compensate being subjected to an increased level of risk. It is used widely in finance and economics, the general definition being the expected risky return less t ...

for investing in the risky security. Liquidity risk premiums are recommended to be used with longer term investments, where those particular investments are illiquid. Assets that are traded on an organized market are more liquid. Financial disclosure requirements are more stringent for quoted companies. For a given economic result, organized liquidity and transparency make the value of quoted share higher than the market value of an unquoted share.

Pricing Liquidity Premium

Practitioners struggle with the valuation of illiquid securities. Longstaff (1995) calculates the upper bound for this premium by assuming that without trading restrictions, an investor with perfect market-timing ability can sell a security at its maximum price during the period in which the security is restricted from trading. Thus, the upper bound for the liquidity premium is priced as the difference between this maximum price during the restricted trading period and the security price at the end of this period. Abudy and Raviv (2016) extend this framework for the special case of corporate bonds by using a structural approach for pricing a corporate security. Consistent with the empirical literature the liquidity premium is positively related to the issuing firm’s asset risk and leverage ratio and increases with a bond’s credit quality. The term structure of illiquidity spread has a humped shape, where its maximum level depends on the firm’s leverage ratio.

References

Economic theories Investment {{fin-theory-stub

Pricing Liquidity Premium

See also

References