Liquidity Premium
What It Is
The liquidity premium is the extra return investors demand for holding assets that are harder to buy or sell quickly.
Why It Matters
Illiquid assets carry higher risk, so investors require compensation for the difficulty of exiting positions.
How It Works
- Illiquid assets → higher required returns
- Liquid assets → lower required returns
- Premium varies with market conditions
- Increases during stress or uncertainty
Key Components
- Liquidity risk
- Transaction costs
- Market depth
- Investor behavior
Example
Small‑cap stocks often offer higher expected returns partly due to their lower liquidity.
Key Takeaways
- Liquidity premium compensates for trading difficulty.
- It rises during volatile periods.
- It influences asset pricing and portfolio construction.