1. What is Liquidity Premium?

The liquidity premium is the additional return investors demand for holding assets that cannot be easily converted to cash without a significant loss in value. It compensates investors for the risk of not being able to sell the asset quickly at its fair market value.

2. How Does the Calculator Work?

The calculator uses the liquidity premium formula:

Where:

• \( \text{Yield} \) — Total yield of the investment (in decimal form)
• \( \text{Risk-Free Rate} \) — Return of risk-free assets like Treasury bills (in decimal form)
• \( \text{Other Premiums} \) — Any other risk premiums included in the yield (default risk premium, maturity premium, etc.)

3. Importance of Liquidity Premium

Details: Understanding liquidity premium helps investors evaluate whether they're being adequately compensated for illiquidity risk. It's particularly important for pricing corporate bonds, private equity, real estate, and other less liquid investments.

4. Using the Calculator

Tips: Enter all values in decimal form (e.g., 5% = 0.05). The yield should be the total promised return of the investment, the risk-free rate should match the investment duration, and other premiums should include all identifiable risk premiums except liquidity.

5. Frequently Asked Questions (FAQ)

Q1: What's a typical liquidity premium?
A: It varies by asset class and market conditions. Corporate bonds might have 0.1%-2% liquidity premium, while private equity could be much higher.

Q2: How does liquidity premium change during crises?
A: Liquidity premiums typically spike during financial crises as investors demand higher compensation for illiquidity.

Q3: Is liquidity premium always positive?
A: Generally yes, as more liquid assets typically have lower yields. However, in rare cases with negative-yielding bonds, it might appear negative.

Q4: How does this differ from liquidity discount?
A: They're two sides of the same coin - the premium is the extra yield demanded, while the discount is the price reduction accepted for illiquid assets.

Q5: Can this be used for all asset classes?
A: The concept applies broadly, but the calculation may need adjustments for complex instruments with embedded options.