Liquidity factor and illiquidity premium
â¢ Liquidity is a nebulous, multi-faceted concept which the events of 2007â2008 brought to the attention of all market players.
â¢ Privately traded assets tend to be less liquid than publicly traded assets, alternatives less liquid than traditional assets, small-cap stocks less liquid than large-cap stocks, and non-government bonds less liquid than Treasuries.
â¢ It is clear that liquidity-related premia have a significant impact on expected asset returns. Both the illiquidity characteristic and an assetâs tendency to underperform amid liquidity droughts warrant higher required returns.
â¢ These pricing effects are hard to empirically disentangle from each otherâor from other asset premia. Yet, long-run average returns appear consistently higher for less liquid assets. The flip side is that liquidity droughts tend to coincide with other aspects of bad times, such as equity meltdowns and recessions.
â¢ Liquidity premia vary over timeâa fact that became abundantly clear in recent years. Many ex ante liquidity premia were driven through competition to record-low levels in 2006â2007, and then they widened to record-wide levels in 2008 when the demand for liquidity rose and the supply for it plummeted. The reward for liquidity provision over time is empirically related to measures of illiquidity and to market volatility.
â¢ True long-horizon investors have a natural edge in harvesting illiquidity premia, and they should exploit ...