What do you understand by the term liquidity premium?

Liquidity premium

Liquidity premium or the illiquidity premium stands for the extra return which can be bagged by the investor from an investment that cannot be turned into cash immediately. All the risk-averse investors mostly avoid investment in such illiquid assets

What if the premium is high?

When the liquidity premium is high, the asset is considered to be illiquid. The investors expect a premium or risk premium for investing in risky security. The premiums are recommended to be used with long-term investments, where particular investments should be illiquid.

The assets whose trading is practiced in an organized market are more liquid. Quoted companies require more stringent financial disclosure.

Pricing

The valuation of illiquid securities is a difficult task for practitioners. In order to calculate the upper bound for this premium, an assumption was made that an investor with sound knowledge in marketing timing could be able to sell a security without trading restrictions. That implies the calculation was made on the basis of the difference between this maximum price during the restricted period of trading and the security price after the cessation of this period. The liquidity premium is positively related to the firm asset risk and the leverage ratio that increases with a bond’s credit quality.

Published: June 7, 2019 | Modified:September 17, 2020

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