Liquidity—the ability to buy and sell significant quantities of a given asset, quickly, at low cost and without a major price concession—is valuable to investors. Therefore, they demand a premium as compensation for the greater risks and costs of investing in less liquid securities.
For example, liquidity risk partly explains the equity-risk premium. The average transaction costs on stock trades are far larger than they are on Treasury bills, which can be traded in large blocks of tens of millions of dollars in a single transaction without affecting their price.
The academic research has found that the illiquidity premium in stocks is positive and highly significant worldwide after controlling for global and regional common risk factors (such as beta, size and value).
Negativity Effect
Another important finding from the research is that the market requires a higher premium for liquidity sacrifice in negative environments, when investors holding illiquid equities become liquidity takers (divesting them, either to meet liquidity needs or due to panicked selling) and pay a steep price to do so. In other words, the liquidity premium is conditional on the state of the market—it’s much smaller in good times and much larger in bad times.
The finding of a liquidity premium is consistent with economic theory, which holds that assets that perform poorly in bad times (when marginal utility of consumption is higher) should carry large premiums. And what’s more, illiquid stocks (which tend to be smaller stocks) have greater sensitivity to liquidity shocks and thus also should carry premiums (helping to explain the size premium).
Stocks whose systematic liquidity risk rise more when funding illiquidity is worse have higher expected return. The finding of a liquidity premium also holds for corporate bonds. Corporate bond illiquidity increases monotonically when moving from safer bonds to riskier bonds, helping to explain their incremental yield.
Liquidity Preference
To summarize the theory and literature on equities and liquidity, investors care about stock illiquidity and thus demand higher expected returns on stocks that are more illiquid. Variations in illiquidity affect stock valuations.
Thus, investors not only prefer assets that are more liquid, they also prefer assets that have smaller exposure to liquidity shocks. In other words, they prefer assets whose prices fall less when market illiquidity rises, assets whose illiquidity rises less when market illiquidity rises, and assets whose illiquidity rises less when there is a marketwide decline in prices.
