The liquidity risk premium is the compensation that a lender receives for
investing funds in something that is difficult to sell. The old adage "risk
is having your money available when you need it", applies.
Let's say you invest in a five year bond of Kamikaze Corporation at 8%. You
hold it for the first two years of the term and then your spouse wants to
redecorate, or go on vacation. You decide to sell this bond on the secondary
market and phone your broker. The broker giggles. What? It seems that the
Kamikaze Corporation, after showing initial promise, took a big dive in
profitability. The best bid he can muster is $50 per $100 par value. This
doesn't necessarily mean that the bond won't pay its interest, only that the
situation is not clear. A buyer has to be lured in by a very large price
discount. Normally the liquidity risk premium is thought of in terms of yield. A
highly liquid Government of Canada bond would trade with 1 or 2 "basis
points" (1/100 of a percent of yield) difference between the bid and ask
yield. A good quality, but less liquid, corporate bond might have 5-10 basis
points between the bid and ask yield. When markets are highly volatile, the
differential even on Canada bonds can be quite wide. |