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In: Finance

Describe the liquidity premium. What are its uses in determining the term structure of interest rates?

Describe the liquidity premium. What are its uses in determining the term structure of interest rates?

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Expert Solution

Liquidity Premium: It is a premium demanded by investors when any given security cannot be easily converted into cash for its fair market value. When the liquidity premium is high, the asset is said to be illiquid, and investors demand additional compensation for the added risk of investing their assets over a longer period of time since valuations can fluctuate with market effects.

Uses of Liquidity Premium in determining the term structure of interest rates:

The liquidity premium theory of interest rates is a key concept in bond investing. It follows one of the central tenets of investing: the greater the risk, the greater the reward. The theory is one of several that collectively seek to explain the shape of the yield curve -- the interest rates that investors receive for buying bonds of different maturities. One of the most closely watched graphs among investors is the yield curve, also known as the term structure of interest rates. It plots the yields, or investment returns, of a specific category of bonds on the y-axis against time on the x-axis. Liquidity refers to how quickly an asset can be sold without lowering its price. Generally speaking, markets with many participants are highly liquid relative to markets with fewer participants. The liquidity premium theory states that bond investors prefer highly liquid, short-dated securities that can be sold quickly over long-dated ones. The theory also contends that investors are compensated for higher default risk and price risk from changes in interest rates. Investors demand a liquidity premium for longer dated bonds. This theory has a natural bias toward a positively sloped yield curve.


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