Liquidity premium

Examples of Liquidity premium in the following topics:

• Premiums

  • Another form of consumer sales promotion is the premium.
  • In the United States, each year over $4.5 billion is spent on premiums.
  • Premiums fall into one of two categories: free premiums which only require the purchase of the product and self-liquidating premiums which require consumers to pay all, or some, of the price of the premium.
  • Self liquidating premiums require the consumer to pay an amount of money for a gift or item.
  • Self-liquidating premiums require consumers to pay an amount of money for a gift or an item.

• The Term Structure

  • The liquidity premiumtheory asserts that long-term interest rates not only reflect investors' assumptions about future interest rates but also include a premium for holding long-term bonds (investors prefer short-term bonds to long-term bonds).
  • This is called the term premium or the liquidity premium.
  • Because of the term premium, long-term bond yields tend to be higher than short-term yields, and the yield curve slopes upward.
  • Long-term yields are also higher not just because of the liquidity premium, but also because of the risk premium added by the risk of default from holding a security over the long-term.
  • If investors prefer their portfolio to be liquid, they will prefer short-term instruments to long-term instruments.

• The Yield Curve

  • The liquidity premium theory asserts that long-term interest rates not only reflect investors' assumptions about future interest rates, but also include a premium for holding long-term bonds (investors prefer short term bonds to long term bonds), called the term premium or the liquidity premium.
  • This premium compensates investors for the added risk of having their money tied up for a longer period, including the greater price uncertainty.
  • Because of the term premium, long-term bond yields tend to be higher than short-term yields, and the yield curve slopes upward.
  • Long term yields are also higher not just because of the liquidity premium, but also because of the risk premium added by the risk of default from holding a security over the long term.
  • If investors prefer their portfolio to be liquid, they will prefer short-term instruments to long-term instruments.

• The Promotion Mix

  • Examples of sales promotion include: Coupons, sweepstakes, contests, product samples, rebates, tie-ins, self-liquidating premiums, trade shows, trade-ins, and exhibitions.
  • Examples: Coupons, sweepstakes, contests, product samples, rebates, tie-ins, self-liquidating premiums, trade shows, trade-ins, and exhibitions.

• Drivers of Market Interest Rates

  • Market interest rates are mostly driven by inflationary expectations, alternative investments, risk of investment, and liquidity preference.
  • This means that a lender generally charges a risk premium to ensure that, across his investments, he is compensated for those that fail.
  • Liquidity preference: People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time or money to realize.
  • where in is the nominal interest rate on a given investment, ir is the risk-free return to capital, pe = inflationary expectations, i*n = the nominal interest rate on a short-term risk-free liquid bond (such as U.S.
  • Treasury Bills), rp = a risk premium reflecting the length of the investment and the likelihood the borrower will default, lp = liquidity premium (reflecting the perceived difficulty of converting the asset into money and thus into goods).

• Liquidity and Bond Prices

  • Liquidity causes bond prices and interest rates to differ.
  • For instance, U.S. government securities are widely traded and are the most liquid.
  • Consequently, the investors are attracted to the government bonds because they are more liquid.
  • Taking the difference between the two interest rates, we measure the degree of liquidity.
  • Nevertheless, economists refer the difference in interest rates as a risk premium.

• The Savings Association Insurance Fund (SAIF)

  • In the 1990s, SAIF premiums were, at one point, five times higher than BIF premiums; several banks attempted to qualify for the BIF, with some merging with institutions qualified for the BIF to avoid the higher premiums of the SAIF.
  • This drove up the BIF premiums as well, resulting in a situation where both funds were charging higher premiums than necessary.
  • In the 1990s, SAIF premiums were, at one point, five times higher than BIF premiums.
  • The FDIC maintains the DIF by assessing depository institutions an insurance premium.
  • Typically, bank failures represent a cost to the DIF because the FDIC, as receiver of the failed institution, must liquidate assets that have declined substantially in value while, at the same time, making good on the institution's deposit obligations.

• Default Risk and Bond Price

  • Businesses and governments offer a variety of bonds that differ in default risk, liquidity, information costs, and taxes.
  • Risk premium is always positive.
  • As the default risk increases, then the risk premium increases too.
  • During recessions, when some businesses bankrupt, the default risk increases, increasing the risk premium.
  • Impact of a risk premium on the bond markets

• Answers to Chapter 9 Questions

  • Investors prefer to hold liquid securities.
  • Thus, investors increase their demand for the highly liquid bonds and decrease their demand for the low liquid ones.
  • Consequently, bond prices increase for the liquid bonds but decrease for the non-liquid bonds.
  • Moreover, the interest rates are lower for the liquid bonds and higher for the non-liquid bonds.
  • However, they are persuaded to invest in a longer-term security if they receive a higher interest rate, the term premium.

• Regulatory Oversight

  • Currently, U.S. banks pay modest premiums only on domestic deposits.
  • If the Federal Deposit InsuranceCorporation (FDIC) requires U.S. banks to pay deposit insurance on all accounts, including foreign accounts, then their premiums would increase.
  • Central banks from Britain, European Union, and Japan can borrow U.S. dollars from the Federal Reserve through the U.S. dollar liquidity swap.
  • A U.S. dollar liquidity swap is a central bank can borrow U.S. currency from the Federal Reserve by giving its own currency as collateral.
  • If banks hold more capital or hold more liquid assets, then they would have more capital to deal with a financial crisis.