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Liquidity premium is a term used to refer to the difference in value of investments based on the liquidity of the investment. Liquidity means the level of ease with which an investment can be turned into cash. Often, the more liquid the investment is, the less risky it is to investors.
A liquid investment carries less risk because the investor's money is not tied up in the investment for long periods of time. The investor can thus sell if a better investment comes along or if the original investment is not performing as expected. Since selling is easy, less of a commitment is made to the investment and the investor thus has less risk of things going bad and being stuck within the poor investment.
As a result of the increased value of liquidity, a liquidity premium refers to the added value of a liquid investment. For example, publicly held stocks are normally more liquid than privately held companies and more liquid than real estate assets. This is the case because a publicly held stock can normally be traded at any time on a stock market or stock exchange and investors aren't required to hold the stocks for any given period of time.
In order for an investor to invest in a less liquid asset, such as real estate or a privately held company, that investment must have different features or attributes that make up for its lack of liquidity. In other words, it must pay a higher rate of return, be less risky than the stock, or both. When an investor compares his investment options, he thus considers all these factors and compares them to determine what is the best investment.
A liquidity premium explains the difference in interest rates between short- and long-term bonds as well. A short-term bond is more liquid. The investor is tied in for a limited period of time and can then turn his asset into cash, while with a longer term bond he must hold on to the bond for a lengthier period of time and so the asset is less liquid; the shorter term bond thus has a liquidity premium.
As a result, the longer term bonds normally have a higher interest rate than shorter term bonds. The investor takes on more risk because if interest rates rise during the time period he is locked into the bond, he will not be able to trade in his existing bond for a bond paying a higher interest rate. On the other hand, he would be able to sell his shorter term, more liquid bond to trade into a better-paying investment; so the liquidity premium exists because the shorter term bond gives him more flexibility.
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