<![CDATA[First things first, an illiquidity premium and a liquidity premium are basically different ways of describing the same thing. Although the term illiquidity premium is used in the context of Solvency II, liquidity premium is more widely used and easier to understand.
LiquidityLiquidity denotes the ease with which an asset can be traded. Conversely, illiquidity is the measure of difficulty of trading the asset. Therefore liquidity is a measure of the ‘tradability’ of an asset. Illiquid assets are generally cheaper because their owner carries the risk involved in disposing of it.
The liquidity premiumSo if you hold two bonds with the same duration and coupon (the stated interest rate) but one of them is more difficult to sell (thus illiquid) you would demand a premium as compensation for taking on the additional risk – the risk you might encounter when trying to sell the bond. That premium comes in the form of a reduced price of the illiquid bond. The liquidity premium is the difference in the price (the spread) of two identical assets with different liquidities. Identical assets have the same characteristics (duration, risk, cash flows, etc.) they only differ by the ease with which they can be traded.
Liquidity premium or illiquidity premium?The terms ‘liquidity premium’ and ‘illiquidity premium’ are interchangeable depending on where you apply the premium (because the interest rate and price have an inverse relationship):
- illiquidity premium – attributes the premium to the illiquid asset’s yield (or interest),
- liquidity premium – attributes the premium to the liquid asset’s price.
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