Damodaran on Valuation

14.3. COST OF ILLIQUIDITY: EMPIRICAL EVIDENCE

If we accept the proposition that illiquidity has a cost, the next questions become empirical ones. How big is this cost? What causes it to vary across time and across assets? The evidence on the prevalence and the cost of illiquidity is spread over a number of asset classes. In this section, we begin by considering the price attached to illiquidity in the bond market and then move on to the equity market. In the final part of the section, we look at the illiquidity effects on private equity investments and real assets.

14.3.1. Bonds

There are wide differences in liquidity across bonds issued by different entities, and across maturities for bonds issued by the same entity. These differences in liquidity offer us an opportunity to examine whether investors price liquidity and if so, how much, by comparing the yields of liquid bonds with otherwise similar illiquid bonds. Studies of bond market liquidity have looked at the Treasury bond, corporate bond, and subordinated bond markets.

• Treasury bills/bonds. Amihud and Mendelson (1991) compared the yields on Treasury bonds with less than six months left to maturity with Treasury bills that have the same maturity.^[] They concluded that the yield on the less liquid Treasury bond was 0.43 percent higher on an annualized basis than the yield on the more liquid Treasury bill, a difference that they attributed to illiquidity. A subsequent study by Kamara (1994) confirmed their finding and concluded ...