What is the 'Liquidity Premium'

Liquidity premium is a premium demanded by investors when any given security cannot be easily converted into cash for its fair market value. When the liquidity premium is high, the asset is said to be illiquid, and investors demand additional compensation for the added risk of investing their assets over a longer period of time since valuations can fluctuate with market effects.

BREAKING DOWN 'Liquidity Premium'

Liquid investments are known as those that can be easily converted to cash at their fair market value. Investment terms may allow for easy convertibility, or there may be an active secondary market for which the investment can be traded. Illiquid investments in the market are the opposite of liquid investments since they cannot be easily converted to cash at their fair market value. Illiquid investments can take many forms. These investments include certificates of deposit (CDs), loans, real estate and other investment assets where the investor is required to remain invested for a specified period of time. These investments cannot be liquidated, withdrawn without a penalty or actively traded on a secondary market for their fair market value.

Investment Commitment

Illiquid investments require investors to commit for the entire investment period. Investors in these illiquid investments expect a premium, known as the liquidity premium, for the risk of locking up their funds over a specified period of time. Often the terms illiquidity premium and liquidity premium can be used interchangeably to mean the same thing. Both terms infer that an investor should receive a premium for a longer-term investment.

The shape of the yield curve can further illustrate the liquidity premium demanded from investors for longer-term investments. In a balanced economic environment, longer-term investments demand a higher rate of return than shorter-term investments, thus the upward sloping shape of the yield curve.

In an additional 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 is not willing to pay as much for the nonpublic bond, thus receiving a greater premium at maturity. The difference in prices and yields is called the liquidity premium.

Overall, investors who choose to invest in longer-term illiquid investments want to be rewarded for the added risks. Additionally, investors who have the capital to invest in longer-term investments are able to benefit from the liquidity premium earned from these investments.

RELATED TERMS
  1. Illiquid

    The state of a security or other asset that cannot easily be ...
  2. Flight To Liquidity

    A situation where investors attempt to liquidate positions in ...
  3. Liquid Asset

    An asset that can be converted into cash quickly and with minimal ...
  4. Liquidity

    The degree to which an asset or security can be quickly bought ...
  5. Premium Put Convertible

    A convertible bond with an additional put feature that allows ...
  6. Illiquid Option

    An option contract that cannot be sold for cash quickly at the ...
Related Articles
  1. Managing Wealth

    When Introducing Illiquidity to Your Portfolio Makes Sense

    Find out when you should consider adding illiquid investments to your portfolio, such as real estate or locked-up investment funds.
  2. Investing

    Understanding Financial Liquidity

    Understanding how this measure works in the market can help keep your finances afloat.
  3. Investing

    Understanding Liquidity Risk

    Make sure that your trades are safe by learning how to measure the liquidity risk.
  4. Financial Advisor

    Why Liquidity Matters in the Corporate Bond Market

    Professional analysis and constant monitoring of liquidity risk when investing in corporate bonds is highly important.
  5. Financial Advisor

    Small Cap Investing: How to Think About Illiquidity

    Do your homework, have a long term view, exercise patience, you'll find that investing in small market capitalization stocks is no riskier than investing in large stocks
  6. Investing

    Understanding Liquidity Risk

    Learn about the two types of liquidity risk: funding liquidity risk and market liquidity risk.
  7. Insights

    What is Liquidity Risk?

    Liquidity risk is the risk of being unable to sell an asset fast enough to avoid loss.
  8. Insurance

    Explaining Premiums

    Premium has a few different meanings in the financial world.
  9. Financial Advisor

    Understanding Life Insurance Premiums

    When buying permanent life insurance, what amount of premium should you pay for the coverage?
  10. Investing

    Understanding Short-Term Investments

    These are investments that have a maturity date of less than one year, or will be liquidated within a year.
RELATED FAQS
  1. What is the difference between a bank's liquidity and its liquid assets?

    Understand the relationship between a bank's liquid assets and its liquidity and how the financial crisis demonstrated the ... Read Answer >>
  2. What affects an asset's liquidity?

    Learn about what affects an asset's liquidity, including examples of liquid and fixed assets, and how a company's liquidity ... Read Answer >>
  3. What is liquidity management?

    Take a look at the different definitions of liquidity, and find out how investors and businesses attempt to reduce exposure ... Read Answer >>
  4. What are some of the risks of holding liquid assets?

    Find out how the holders of liquid assets assume risks associated with opportunity cost and inflation in exchange for solvency ... Read Answer >>
  5. What items are considered liquid assets?

    Learn what a liquid asset is, some examples of liquid assets, what a non-liquid asset is and what determines whether as asset ... Read Answer >>
  6. What is the impact of inflation on liquid assets?

    Find out why inflation is particularly problematic for liquid assets, and learn what holders of liquid assets can do when ... Read Answer >>
Hot Definitions
  1. Market Capitalization

    The total dollar market value of all of a company's outstanding shares. Market capitalization is calculated by multiplying ...
  2. Expense Ratio

    A measure of what it costs an investment company to operate a mutual fund. An expense ratio is determined through an annual ...
  3. Mezzanine Financing

    A hybrid of debt and equity financing that is typically used to finance the expansion of existing companies. Mezzanine financing ...
  4. Long Run

    A period of time in which all factors of production and costs are variable. In the long run, firms are able to adjust all ...
  5. Quasi Contract

    A legal agreement created by the courts between two parties who did not have a previous obligation to each other. A normal ...
  6. Wage-Price Spiral

    A macroeconomic theory to explain the cause-and-effect relationship between rising wages and rising prices, or inflation. ...
Trading Center