The liquidity premium is a term that is used to describe an extra compensation in the form of higher returns that is built in to an asset when it can’t be cashed out quickly or easily. As the liquidity of an asset is an indication of the amount of risk associated with it, investments that require more time or effort to convert into cash generate a higher return in order to be a worthwhile option. Generally speaking, the more illiquid an investment, the higher rate of return that comes with it.

By way of example, consider two investments. The first is a deposit in a savings account that could be exchanged for cash at any time. The second is a long-term portfolio of various stocks and bonds that would take some time to liquidate. This portfolio is characterized by a longer time horizon and higher liquidity premium. The higher level of risk taken on when investing over a longer period of time is factored in the form of a higher liquidity premium.

The liquidity premium is an important concept for investors to be aware of because it impacts the cost of capital for companies. The higher the liquidity premium, the more expensive it is for a company to borrow money. It affects the fees that companies must pay when they use borrowing as a means of financing their operations, as well as their cost of equity should they decide to do a public offering.

For individual investors, recognizing the liquidity premium associated with certain investments can help you make better decisions. For instance, you may want to focus more on liquid investments if you’re trying to protect yourself against a potential recession or bear market. You would also be wise to pay attention when making decisions regarding long-term investments, as you can account for the added liquidity premium baked into these options to determine if the returns being offered justify the risk being taken.

In summary, the liquidity premium is an extra portion of return provided to compensate investors for the liquidity risk associated with the investment. As such, it is important for investors to be aware of the different types of investments and the liquidity premiums that they can come with. Doing so can help you make more informed decisions and maximize your returns.