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Liquidity Premium: Definition, Examples, and Risk - Topdanangcity

Liquidity Premium: Definition, Examples, and Risk

The terms illiquidity premium and liquidity premium are used interchangeably. Both mean that an investor receives an incentive for an investment not easily convertible into cash. Excluding accounts receivable, as well as inventories and other current assets, it defines liquid assets strictly as cash or cash equivalents. There is little room for negotiation or selling your liquid assets for more than their market value. While liquid assets provide greater security, they may not offer a great return.

Such stocks will also attract a larger number of market makers who maintain a tighter two-sided market. This article does not provide any financial advice and is not a recommendation to deal in any securities or product. Investments may fall in value and an investor may lose some or all of their investment.

  1. In practice, the value of the asset is first calculated ignoring the fact that it is illiquid, and then at the end of the valuation process, a downward adjustment is made (i.e. the illiquidity discount).
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  3. The two main measures of liquidity are market liquidity and accounting liquidity.

Company B, though, is privately held and is offered in a private equity deal, which means it likely has restrictions on when and how you can liquidate your stake. Because of this, Company B will probably come with higher promised returns since its shares are not as easily converted to money. The simplest way to calculate a liquidity premium is to compare similar investments, one of which is liquid and one of which is not. For example, you could compare two bonds from companies with similar credit ratings. If one bond is publicly traded and one bond is not traded on the open market, they will likely have different yields, with the one that is publicly traded providing a lower return.

Other liquid assets include stocks, bonds, and other exchange-traded securities. Tangible items tend to be less liquid, meaning that it can take more time, effort, and cost to sell them (e.g., a home). Investors, then, will not have to give up unrealized gains for a quick sale.

SmartAsset Advisors, LLC (“SmartAsset”), a wholly owned subsidiary of Financial Insight Technology, is registered with the U.S. SmartAsset does not review the ongoing performance of any RIA/IAR, participate in the management of any user’s account by an RIA/IAR or provide advice regarding specific investments. Tony Davidow is senior alternatives investment strategist at the Franklin Templeton Institute. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. Patience in terms of timing an exit can often benefit long-term return prospects.


Can You Have a Negative Liquidity Premium?

For example, early-stage investors (e.g. venture capital) require illiquidity discounts because of the long-term holding period for when their capital contribution is locked up. The more illiquid an asset is, the greater the discount expected by investors for the incremental risk of purchasing an investment with limited flexibility of selling in the future. In that case, according to the Securities and Exchange Commission (SEC), sell algorithms were feeding orders into the system faster than they could be executed. According to the SEC, “especially in times of significant volatility, high trading volume is not necessarily a reliable indicator of market liquidity.” Depth refers to the ability of the market to absorb the sale or exit of a position. An individual investor who sells shares of Apple, for example, is not likely to impact the share price.

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On the other hand, an institutional investor selling a large block of shares in a small capitalization company will probably cause the price to fall. Finally, resiliency refers to the market’s ability to bounce back from temporarily incorrect prices. In addition to trading volume, other factors such as the width of bid-ask spreads, market depth, and order book data can provide further insight into the liquidity of a stock. So, while volume is an important factor to consider when evaluating liquidity, it should not be relied upon exclusively. Liquidity refers to the efficiency or ease with which an asset or security can be converted into ready cash without affecting its market price.

An Illiquid asset is difficult to convert into cash quickly without a substantial loss in value. A liquid asset is one that can be quickly sold without a significant loss in value; an illiquid asset is one that can’t be quickly resold without a significant loss in value. Most stocks are also considered liquid assets because, even though they are not actual cash, there is a readily available market to sell them quickly. The whole idea of the illiquidity premium is to benefit from the fact that the asset isn’t traded heavily. The illiquidity premium happens because when markets are illiquid, the purchase or sale of an asset can move prices substantially, even if the purchase or sale happens in small quantities.

What Is Illiquid?

A liquidity trap is a macroeconomic scenario in which cash is preferable because it is highly liquid. Bonds come with an agreed term, so selling early to access the cash could incur a loss. For instance, in a deflationary environment, the stock may lose its liquidity and, thus, its value.

Understanding an asset’s liquidity is an essential part of risk management and portfolio strategy. Thus, depending on the circumstances, the illiquidity discount can be as low as 2% to 5%, or as high as 50%. Under these assumptions, we can say “only 1/20 days (5% of the time) do we expect the daily loss to exceed $16,500.” But this does not adjust for liquidity.

The two main measures of liquidity are market liquidity and accounting liquidity. Market liquidity relates to the extent to which a market, such as a stock market, allows assets to be bought and sold at stable and transparent prices. Illiquidity is essential to many aspects of both accounting and investing. From an accounting perspective, reporting liquid assets is a requirement of many different forms of financial disclosures. A company may have to distinguish its liquid and illiquid assets for the Internal Revenue Service, the Securities and Exchange Commission, lenders, potential investors and shareholders, just to name a few. Illiquid securities carry higher risks than liquid ones, known as liquidity risk, which becomes especially true during times of market turmoil when the ratio of buyers to sellers is thrown out of balance.

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For example, a long-term bond will carry a higher interest rate than a short-term bond because it is relatively illiquid. The higher return is the liquidity premium offered to the investor as compensation for the additional risk. An asset is said to be “liquid” if traders can convert it quickly to cash without materially affecting its market price. The market for large cap stocks is liquid because equity claims are relatively homogeneous and there are normally large numbers of buyers and sellers trading on centralized exchanges. Most bond markets are highly illiquid, primarily because bonds are highly idiosyncratic. Even bonds issued by the same entity normally differ along several dimensions, including maturity, coupon rate, and covenants.

Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs. Yarilet Perez is an experienced python exponential multimedia journalist and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more. Her expertise is in personal finance and investing, and real estate.

For individuals, a home, a time-share, or a car are all somewhat illiquid in that it may take several weeks to months to find a buyer, and several more weeks to finalize the transaction and receive payment. Moreover, broker fees tend to be quite large (e.g., 5% to 7% on average for a real estate agent). Until recently, high-net-worth investors had limited access to these elusive investments due to investor eligibility and high minimums. The size of the illiquidity discount is largely up for debate, but for most private companies, the discount tends to range between 20-30% of the estimated value as a general rule of thumb. Illiquidity describes assets that cannot be readily sold in the open market — which usually warrants a discount to be attached to the valuation due to the absence of marketability. The most liquid stocks tend to be those with a great deal of interest from various market actors and a lot of daily transaction volume.

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