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How Liquidity Premiums Are Calculated and Paid

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A liquidity premium is the extra compensation required to get an investor to buy a security that is more difficult to sell quickly at a fair market price than an alternative. In other words, a security with a high liquidity risk – that is, one that is difficult to sell relatively quickly at a fair price – must offer a buyer something extra than what a more liquid alternative offers. That “something extra” is known as the liquidity premium. Here’s what you need to know about this key investing metric. A financial advisor can help you to use this premium as you consider additions to your portfolio.

Investment Liquidity, Defined

If you ever need to utilize a portion of your investment portfolio for an unexpected expense, you’ll find that certain assets will be easier than others to convert to cash. This is called the investment’s liquidity.

An investment asset’s liquidity is its ability to be sold rather quickly and easily, at (or close to) fair market value. Some assets, such as savings accounts or short-term securities like Treasury bills, can be liquidated with ease. Investors simply need to withdraw the funds, cash out the certificates or sell the stock on the public market.

Others are a bit more troublesome to convert, however, and are considered illiquid investments. Certificates of deposit (CDs), for example, may result in penalties or even a loss if they are liquidated prior to maturity. An asset such as a home can take time and money to liquidate, even in a seller’s market. And securities that are not publicly traded may be very valuable in your investment portfolio but are often difficult or time-consuming to sell.

It’s wise to keep a portion of your investments liquid, in case you need access to those assets. However, illiquid investments also have an important role in your portfolio. That’s because illiquid securities can offer investors added compensation – the so-called “premium” – in exchange for assuming a greater liquidity risk.

Examples of Liquidity Premiums

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An investment’s liquidity premium is built into the actual return of that investment. This often comes in the form of a higher interest rate or larger payout at maturity. Investors only need to look at their investment options to see how liquidity premiums play out in actual practice. Liquidity premiums are the reason you’ll find five-year CDs offering much higher returns than six-month CDs. You’ll also notice that no-penalty CDs generally have lower returns than normal CDs of the same length, which charge an early withdrawal fee.

Government securities are another example. Treasury bills have a maturity date ranging anywhere from only a few days to one year in length. If you buy one you can be assured that your money won’t be tied up for long. As a result, they traditionally offer much lower returns than other government securities.

Treasury bonds, however, offer maturities of either 20 or 30 years, with much higher rates of return than Treasury bills. Even if you were to hold a Treasury bill for 20 years, its value still wouldn’t reach that of a 20-year Treasury bond.

How to Calculate Liquidity Premiums

Calculating a liquidity premium is quite simple, depending on the security you are considering.

The easiest way to gauge liquidity premiums is to simply calculate the yield curve, or realized return, of two investments with different levels of liquidity. Assume, for example, that two bonds have the same initial investment and the same growth rate. However, one investment will mature earlier than the other, meaning it would be more liquid.

Meanwhile, the longer-dated investment continues to provide returns for the investor. After the last period of maturity ends, the difference in yield between the two investments represents the liquidity premium.

The Bottom Line

An investor calculates a liquidity premiumWhen choosing how to build their portfolios, investors need to balance risk with potential returns. In most cases, the higher the risk you’re willing to take, the higher the potential reward. Depending on how and when you plan for those invested funds to be utilized, you may choose to invest in either liquid or illiquid assets. This difference is the investment’s liquidity premium, and it’s a key metric, especially for fixed-income investors.

Tips on Investing

  • It’s important that your investments are a good match for your risk profile and timeline. That’s where a financial advisor can be an especially vital guide. Finding one doesn’t have to be hard. SmartAsset’s matching tool can connect you to several financial advisors in your area in just minutes. If you’re ready, get started now.
  • Consider using a free investment calculator to get an estimate on how your portfolio will do over a set number of years.

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