What is the illiquidity premium?
Nov 7th 2019IMAGINE TWO bonds listed on different exchanges that are otherwise identical. The risk-free rate of return is 2%. Investors hold bonds for an average of one year. A central bank acts as market-maker, supplying cash on demand for bonds. To cover its costs, the price the central bank pays (the bid) is a bit below the fair value of a bond, which is the price it requires buyers to pay for it (the ask). The bid-ask spread is the cost of trading. For A-bonds it is 1%. For B-bonds, which are listed on an inefficient exchange that charges higher fees, it is 4%.What is the yield on each bond? It varies with trading costs. Investors on average make one round-trip sale-and-purchase a year. So the yield they demand on A-bonds is 3%. That includes the risk-free rate of 2% plus 1% compensation for trading costs. By the same logic, the yield on B-bonds is 6%. The extra 3% return required on the harder-to-trade security is known as the illiquidity premium.Choose us for news analysis that respects your time and intelligenceSubscribe to The EconomistWe filter out the noise of the daily news cycle and analyse the trends that matterWe give you rigorous, deeply researched and fact-checked journalism. That’s why Americans named us their most trusted news source in 2017Available wherever you are—in print, digital and, uniquely, in audio, fully narrated by professional broadcastersThis website adheres to all nine of NewsGuard‘s standards of credibility and transparency.ORContinue reading this articleRegister with an email address