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Liquidity premium is the added value of a liquid investment due to its ease of conversion to cash, making it less risky for investors. Less liquid assets must offer higher returns or lower risk to compensate. Short-term bonds have a liquidity premium, resulting in higher interest rates than long-term bonds.
Liquidity premium is a term used to refer to the difference in the value of investments based on the liquidity of the investment. Liquidity means the level of ease with which an investment can be converted into cash. Often the more liquid the investment is, the less risky it is for investors.
A liquid investment carries less risk because the investor’s money is not tied to the investment for long periods of time. In this way, the investor can sell if a better investment occurs or if the original investment does not perform as expected. Since selling is easy, less commitment is made to the investment and therefore the investor has less risk of things going wrong and getting stuck inside the bad investment.
As a result of the higher liquidity value, a liquidity premium refers to the added value of a liquid investment. For example, public stocks are typically more liquid than private companies and more liquid than real estate. This is the case because a publicly traded stock can typically be traded at any time on a stock market or stock exchange and investors are not required to hold the shares for any given period of time.
For an investor to invest in a less liquid asset, such as real estate or a private company, that investment must have different characteristics or attributes that compensate for its illiquidity. In other words, he must pay a higher rate of return, be less risky than the stock, or both. When an investor compares his investment options, he considers all of these factors and compares them to determine the best investment.
A liquidity premium also explains the difference in interest rates between short-term and long-term bonds. A short-term bond is more liquid. The investor is tied in for a limited period of time and can then convert their asset to cash, whereas with a longer term bond they must hold the bond for a longer period of time and therefore the asset is less liquid ; The shorter term bond has a liquidity premium.
As a result, longer-term bonds typically carry a higher interest rate than shorter-term bonds. The investor takes more risk because if interest rates rise during the period that he is locked into the bond, he will not be able to redeem his existing bond for a bond that pays a higher interest rate. On the other hand, he could sell his more liquid, short-term bond to trade in a higher-paying investment; So the liquidity premium exists because the short-term bond gives you more flexibility.
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