Liquidity premium is the component of required return which represents compensation for existence of illiquidity and lack of marketability in an investment. It is relevant where an investment can’t be readily converted to cash and there are high transaction costs such as bid-ask spreads.
A liquid investment is one which can be liquidated (i.e. sold) without any significant movement in its market price or excessive transaction costs. It is possible only if an efficient market with a range of buyers and sellers exists for the investment. On the other hand, an illiquid investment is one which must be sold at a price lower than its intrinsic or fair value just because there are not enough willing buyers.
Liquidity premium is a misnomer, it is in fact a premium for lack of liquidity or illiquidity.
Liquidity premium can be defined as the difference between yield on securities which are otherwise identical except for the difference in the breadth and depth of the market that exists for them. One example we can think of is to compare the yield on on-the-run and off-the run US Treasury issues of the same maturity and use the following formula to estimate liquidity risk premium:
Liquidity Risk Premium = YieldOFF - YieldON
Where YieldOFF and YieldON refers to the yield on off-the-run and on-the-run Treasury bonds with the same maturity. On the run Treasury bonds are the most recently issued bonds for which updated market information is available and an active market exists for them while the off-the-run treasury issues are outdated Treasury bonds.
But the above expression is a simplification. There is no fit-all solution to find liquidity premium. One approach is to carry out dissection of historical yield differences to identify appropriate liquidity premium. Another approach is to base the liquidity risk premium on the bid-ask spread that exists for the investment. Some option pricing models also exist which values liquidity as an option.
In case of bonds, liquidity premium increases if we move from good ratings to bad ratings and as we move from shorter maturities to longer maturities.