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 more extended period since valuations can fluctuate with market effects.
Breaking Down Liquidity Premium
Liquid investments are assets 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 These investments cannot be liquidated, withdrawn without a penalty, or actively traded on a secondary market for their fair market value.
Illiquid investments require investors to commit to 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 require 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 to purchase one of two corporate bonds that have the same coupon payments and time to maturity. Considering 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 higher premium at maturity. The difference in prices and yields is 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 can benefit from the liquidity premium earned from these investments.