Liquidity premium

(noun)

Liquidity premium is a term used to explain a difference between two types of financial securities (e.g. stocks), that have all the same qualities except liquidity.

Related Terms

Examples of Liquidity premium in the following topics:

  • 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.

  • 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.

  • Contractual Saving

    • Insurance companies provide protection for people who buy insurance policies.Insurance policy prevents financial hardship, such as a medical emergency, car accident, or the death of a family member.Insurance companies are financial intermediaries because they link the funds from the policyholders to the financial markets.Policyholders make periodical payments to the insurance company called premiums.Insurance company will invest the premiums in the financial
    • markets.For the insurance company to earn a profit, the amount of interest earned in the financial markets plus the total amount of premiums must exceed the amount paid for claims.Largest insurance companies include Allstate, Aetna, and Prudential.Most states established commissions that regulate insurance companies.Commissions may limit premiums, minimize fraud, and prevent the insurance companies from investing in risky securities.
    • Insurance companies use two strategies to combat moral hazard and adverse selection.First, insurance companies gather information about the policyholders, such as driving records, medical records, and credit histories.Consequently, the insurance company charges a higher premium to a person who is likely to file a claim, which we call a risk-based premium.Second, insurance companies use a deductible.When a person makes a claim, the person must pay the first portion.For example, a person buys health insurance with a $500 deductible.After this person has paid the first $500 to a doctor, then the insurance company pays the remainder of the claim.This passes some of the responsibility to the person holding the insurance policy.Finally, a person could buy insurance with smaller premiums but with a greater deductible.
    • First type of insurance company is a life insurance company.These companies purchase long-term corporate bonds and commercial mortgages because they can predict future payments with high accuracy.Furthermore, the insurance companies are organized in two ways: Mutual company or stock company.Insurance policyholders own a mutual company because the insurance policy functions as corporate stock, while a stock company is a corporation that issues stock.Thus, the shareholders own the company, while the insurance policyholders do not.Stock company is more common because a stock company has more funding sources.They receive funding by selling stock to shareholders, and receive revenue by selling insurance policies.Most policies issued are called term life policies.Person buying the life insurance must pay the premium for the rest of his life.These policies are popular because the policyholder can borrow against the value of the life insurance policy, when he retires.Borrowing against insurance is an annuity.An annuity pays a retired person a specific amount of money each year.
    • Second type of insurance company is property and casualty insurance companies.They are organized as either a stock company or mutual company, and they insure against theft, floods, illness, fire, earthquakes, and car accidents.These companies tend to purchase liquid, short-term assets because these companies cannot accurately predict the amount of future claims.Insurance companies charge premiums that correspond to the chance of the event occurring.For example, a homeowner in California would pay a higher premium for earthquake insurance than a homeowner in the Midwest of the United States because California experiences more earthquakes.

  • 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.

  • The "Bond Yield Plus Risk Premium" Approach

    • The risk premium on its equity is 4%.
    • The normal historical equity risk premium for all equities has been just over 6%.
    • In general, an equity's risk premium will be between 5% and 7%.
    • Common methods for estimating the equity risk premium include:
    • Describe the process for the bond yield plus risk premium approach

  • Special Derivatives

    • Thus, the option premiums became pure profits to Barings.
    • Consequently, the investment banks would collect CDS premiums as pure profit.
    • Gamblers only pay the CDS premiums.
    • If Company XYZ does not bankrupt, subsequently, the gamblers lose their bet, the CDS premiums.
    • Finally, Lehman Brothers bankrupted and began liquidating its assets.