lIlliquidity Premium

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.

Reading 14: Cases in Portfolio Management – Institutional

Los 14 (b) Discuss capture of the illiquidity premium as an investment objective

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Shop Actuarial Exams Prep Shop Graduate Admission Exam Prep


    Daniel Glyn
    Daniel Glyn
    2021-03-24
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    2021-03-18
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.
    Nyka Smith
    Nyka Smith
    2021-02-18
    Every concept is very well explained by Nilay Arun. kudos to you man!
    Badr Moubile
    Badr Moubile
    2021-02-13
    Very helpfull!
    Agustin Olcese
    Agustin Olcese
    2021-01-27
    Excellent explantions, very clear!
    Jaak Jay
    Jaak Jay
    2021-01-14
    Awesome content, kudos to Prof.James Frojan
    sindhushree reddy
    sindhushree reddy
    2021-01-07
    Crisp and short ppt of Frm chapters and great explanation with examples.