illiquidity premia

[shanlane]

Hello,

What exactly is meant by "illiquidity premia are generally high and significant"?

Does this mean that illiquid investments are worth more? Worth less? Seem to provide higher returns, lower returns? If so, over (or under) what?

Logically, it would seem like more liquidity would make things worth more, then again, maybe the excess return on illiquid investments in necessary to compensate for the illiquidity.

The link does not seem to be clearly established and the tables from the chapter just make things more confusing. For instance, there is also a statement that says "returns are almost monotonically increasing in portfolio liquidity", but this seems to be backward because I thought going from "low" to "high" meant going from lowest autocorrelation (most liquid) to higest correlation (least liquid).

Thanks!

Shannon

 

[David Harper CFA FRM]

Hi Shannon,

It's a thematic (key) FRM concept after the crisis, in part because, to the extent liquidity problems contributed to the crisis, it alerted a lot practitioners to the fact that many models do not (did not) incorporate a liquidity factor. Your statement "illiquidity premia are generally high and significant" connotes investments/hedge funds, but in general I think your summary is excellent: the excess return on illiquid investments in necessary to compensate for the illiquidity.

With hedge funds as the example, Jaeger asks us to view all excess returns as compensation for risk; e.g., in CAPM, systematic risk (beta) earns excess expected return. Liquidity risk (risk of illiquidity) can be viewed as another risk factor that deserves compensation: if you invest in something illiquid, you demand higher return (an "illiquidity premia") in the form of a lower price.

For example, say market risk premium (MRP) is 4%, Riskfree rate is 3.0%, and a generic security with a beta of 1.0, its only risk, returns a notional of $10 in 5 years. On a grossly simply model, you might be willing to pay $10/(1+7%)^5 = $7.13 today to receive the $10 back in 5 years.

Now add a liquidity risk factor and expand the model to E(r) = Rf + beta*MRP + LiquidityPremium (the additional factor is not unlike the SML in Fama-French; i.e., compensation for small cap).
So maybe in order to incur the liquidity risk, you are now only willing to pay $10/(1+8%)^5 = $6.81
i.e., +1% illiqudity premia, or more precisely, 1% = [your exposure to] * [illiquidity premia]. Just like 3% = 1.0 beta exposure * 4% MRP, we can classify this into APT as term with two components: + 1% excess illiquity return = liquidity exposure * liquidity factor

The reduced price is the same as in valuation; if we value illiquid real estate, we apply an illiquidity discount to reduce the price/value. It is the same as increasing the expected return for the buyer, given the same expected future cash flows.

I hope that helps,