lIlliquidity Premium

An illiquidity premium is a return earned by investors for the commitment of capital for an uncertain amount of time. In other words, it is a charge for the usage of money. Illiquidity, or liquidity premiums as they are also known, are most prevalent in private equity and private real estate. Commonly, there is a positive correlation between the horizon of the liquidity restriction and the illiquidity premium.

Many investors enjoy this enhanced return premium if they can withstand the reduced ability to access ready cash. For these investors, capturing a liquidity premium can be a viable investment return objective, as stated in the IPS. Depending on the desired size or amount of the illiquidity premium, a substantial portfolio size may be necessary.

The Illiquidity Premium as a Put Option

The concept of the illiquidity premium is often explained by comparing it to a put option. Imagine this put option has a strike price matching the marketable price of the illiquid asset at the time of purchase. The marketable price is what the option could be sold for in a free market. The gap between this price and the actual sales price equals the option value at expiration. Estimation is usually required for both of these values, although in certain cases, they may be known.

Traditional put option formula:

$$ \text{Intrinsic value of a put option} = \text{strike price} – \text{current market price} $$

Illiquidity premium formula:

$$ \text{Value of put option} = \text{marketable price} – \text{actual sales price} $$

Isolating the Illiquidity Premium

In practice, it can be difficult to isolate the illiquidity premium. It can often get muddled by the presence of other risk factors such as market, value, and size (in the case of equities), which can be hard to separate. All of this lends credence to liquidity budgeting in facilitating the capture of the illiquidity premium while controlling for risk.

Question

A liquidity premium can best be defined as?

1. A put option with a strike price of the actual asset sale price.
2. An incremental charge is paid for tying up capital for an undefined period of time.
3. A liquidity planning tool that informs liquidity budgeting processes.

Solution

The correct answer is B.

A liquidity premium can be best defined as an incremental charge that is paid for tying up capital for an undefined or extended period of time when investing in less liquid assets.

A is incorrect. This choice describes a put option, which is a financial contract that gives the holder the right, but not the obligation, to sell an asset at a predetermined strike price. A liquidity premium is not a put option; it's a financial concept related to the compensation for holding fewer liquid assets.

C is incorrect. A liquidity premium is not a liquidity planning tool. It is the extra return or cost associated with investing in less liquid assets. While liquidity planning tools may consider liquidity premiums in the budgeting process, the liquidity premium itself is not a planning tool.

Portfolio Management Pathway Volume 2: Learning Module 7: Case Study in Portfolio Management: Institutional; Los 7(b) Discuss capture of the illiquidity premium as a long-term investment strategy