Liquidity Premium

Liquidity Premium refers to the additional return that investors require for holding an Asset that is not easily tradable or converted to cash compared to a more liquid Asset. This premium compensates investors for the risk associated with the potential difficulty in selling the Asset at a fair price in the market.

For instance, if an investor holds a corporate bond that is not frequently traded, they may demand a higher yield compared to a government bond, which is highly liquid. The difference in yield between these two types of Bonds can be considered the Liquidity premium.

In practice, during times of market stress, the Liquidity premium can widen significantly. For example, during the 2008 financial crisis, investors sought the safety of cash and highly liquid Assets, leading to increased yields on less liquid Assets like certain mortgage-backed Securities.

Overall, Liquidity premium serves as a key factor in investment decision-making, influencing Asset pricing and portfolio management.