Liquidity Premium

A liquidity premium refers to compensation provided to investors to incentivize investment in assets with lower liquidity. Conversely, highly liquid assets have high trading volume and can be easily converted into cash without significantly affecting their prices. For example, long-term bonds often have lower liquidity and, consequently, offer higher interest rates compared to more liquid short-term bonds. The increased return on long-term bonds represents the liquidity premium provided to investors due to the higher investment risk. Generally, the poorer the liquidity of an investment, the higher the liquidity premium.