Financial assets that change hands frequently in the market, such as stocks and bonds, are said to be liquid. Relatively obscure assets that are traded infrequently are referred to as illiquid. Because investors naturally prefer liquid assets, the illiquid ones must offer an extra rate of return. This is known as the liquidity risk premium.
The concept of liquidity applies to everything of value. Liquid assets are well known, they're frequently purchased by a large number of people, and they have stable market prices.
A Toyota Camry, for example, is a liquid asset in the automotive world. If you wish to sell a 5-year-old Camry, you can go through classified ads to quickly find out what other sellers are asking. If your asking price is reasonable, you'll probably sell your vehicle pretty quickly.
But if you're selling a 12-year-old MG, the market is much smaller. You'll have a hard time finding a representative market price or potential buyers. It will probably take a long time to sell, and you might have to accept far less than you paid.
Liquidity most visibly manifests itself in financial markets in the bid-ask spread. At any given time, each stock or bond will have an ask and a bid. The bid is what the highest bidding buyer is offering to pay for the stock. The ask is the price that the most reasonable seller wants for the stock.
If you see the figures of $10 - $10.02 next to Ford shares, the bid is at $10 and the ask is $10.02. You can immediately purchase Ford stock at $10.02, since a seller is ready to deliver stock at this price. If you want to sell Ford shares, you can do so right away for $10, because a buyer with cash in hand is ready to pay that price.
The more liquid a financial asset, the smaller the difference tends to be between the ask and the bid; in other words, the narrower the bid-ask spread. Investors prefer liquid stocks because the associated trading costs are less.
Assume that Ford and a small stock trade each around $10 per share, and that each is expected to pay around 50 cents in dividends every year. The bid-ask spread in Ford is $10 - $10.02, but that of the small stock is $9.95 - $10.05. If you purchase Ford today and sell it in a week, and the price does not move during this period, you will lose 2 cents per share. You will have bought at $10.02 and sold at $10. But the same operation in the small stock will cost you 10 cents.
Because it's costly to buy and sell illiquid assets, investors prefer them only if they expect a higher compensation. In our example, practically all investors would buy Ford shares rather than the lightly traded stock. The only way the illiquid stock will also sell for $10 is if it pays more than 50 cents in dividends per year. The higher dividend payment will compensate for the cost of trading.
This additional expected profit is referred to as the liquidity risk premium. The same applies to bonds, valuable metals and all other financial and non-financial assets. The less liquid the asset, the more profit potential it must offer.
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