economics Economics () is a behavioral science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the behaviour and interac ...

, a liquidity premium is the explanation for a difference between two types of financial securities (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 In business, economics or investment, market liquidity is a market's feature whereby an individual or firm can quic ...

. It is a segment of a three-part

theory A theory is a systematic and rational form of abstract thinking about a phenomenon, or the conclusions derived from such thinking. It involves contemplative and logical reasoning, often supported by processes such as observation, experimentation, ...

that works to explain the behavior of

yield curve In finance, the yield curve is a graph which depicts how the Yield to maturity, yields on debt instruments – such as bonds – vary as a function of their years remaining to Maturity (finance), maturity. Typically, the graph's horizontal ...

s for

interest rates An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, ...

. 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 on capital, return (profit) or to gain an advantage (interest). Through this allocated capital the investor usually purchases some species of pr ...

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 Rate of retur ...

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 listed 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