Liquidity Premium

DEFINITION of 'Liquidity Premium'

A premium that investors will demand when any given security can not be easily converted into cash, and converted at the fair market value. When the liquidity premium is high, then the asset is said to be illiquid, which will cause prices to fall, and interest rates to rise.

BREAKING DOWN 'Liquidity Premium'

For example, assume an investor is looking at purchasing one of two corporate bonds , each with the same coupon payments, and time to maturity. Assuming one of these bonds is traded on a public exchange, while the other is not, the investor will not be willing to pay as much for the non-public bond. The difference in prices, and yields, the investor is willing to pay for each bond is called the liquidity premium.

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