The Liquidity Premium

by Zhiwu Chen and Roger G. Ibbotson 06-03-09
Liquidity has many different, but similar meanings. In every case, it is related to the ease of movement. In the banking system, liquidity measures the degree to which loans are made. In the securities markets, liquidity is the ease with which transactions can be made. In valuation, liquidity has an impact on value: The more liquidity an asset has, the more value it has, all other things being equal. The absence of liquidity lowers the value of the asset by the amount of an illiquidity discount.
In the financial crisis, it is quite natural that the financial media are focusing on liquidity in bonds and loans. The president and Congress are providing bailout money so that financial institutions can prop up balance sheets to make it easier for them to start lending again. Corporations, such as automobile manufacturers, are not able to meet their cash flows with their illiquid assets and cannot get sufficient financing. Potentially healthy corporations or individuals are not able to get refinancing as their loans become due.
In this article, we instead focus on liquidity as the ease of executing securities in general, especially equities. We focus on liquidity's impact on valuation and in particular its impact on security returns. We will demonstrate that less-liquid securities have higher expected returns.
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