In finance and economics, liquidity premium refers to a type of investment that cannot be sold at a fair market value. Investors and buyers of certain assets require an additional premium or security on their purchase, which not only secures their investment but is also used as an instrument to encourage stronger investor interest.
A good example of a liquidity premium in long-term bonds that have a higher interest rate compared to short-term bonds as they are considered illiquid.
But long-term bonds have a higher market risk that comes with it, thus investors demand a liquidity premium to help hedge their purchase and market risk factors.
To better understand liquidity premiums, it’s good to also have a look at liquid and illiquid investment types.
Liquid Investments: These are easier investments, and quicker to sell at fair market value. Examples include Treasury Bills and stocks or shares of a company.
Illiquid Investments: For those investments that take longer to sell, and require a lot of additional administration to complete, such as debt instruments like bonds or real estate – investors refer to them as illiquid investments.
The best example of liquidity premiums is with government-purchased bonds. The current U.S. Treasury Bond is 2.94%, a percentage that hasn’t been seen in years.
For a three-month Treasury bill rate, the yield is 0.95%, these bonds have a low risk for the upcoming three months, but looking over a period of ten years, there is more risk involved.
So to ensure investors are enticed by the opportunity, yields are supportive of the liquidity premium practices.
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