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Illiquidity Premium

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There is reason to believe that investing in relatively illiquid investments will, in the long run and on average, yield higher expected returns than a more liquid investment of similar risk.  If this weren't true, then nobody would buy them, which would tend to drive down their price, which would tend to increase the expected returns until it was true.

Viral V. Acharya and Lasse Heje Pedersen, "Asset Pricing with Liquidity Risk," NYU Stern School Working Paper, July 17 2003 (416kb).  Also here.  "It is shown that a security's return depends on its expected illiquidity and on the covariances of its own return and illiquidity with market return and market illiquidity."

Yakov Amihud and Haim Mendelson, "Liquidity and Stock Returns," Financial Analysts Journal, MayJune 1986, pp. 43-48. This paper documents an illiquidity premium for stocks (i.e., the higher the bid-ask spread (a proxy for illiquidity), the higher the expected return).

Yakov Amihud and Haim Mendelson, "The Effects of Beta, Bid-Ask Spread, Residual Risk, and Size, on Stock Returns," Journal of Finance, June 1989, pp. 479-486. Another excellent discussion of this topic.

Yakov Amihud and Haim Mendelson, "Liquidity, Maturity, and the Yields on U.S. Treasury Securities," Journal of Finance, September 1991, pp. 1411-1425. This paper confirms the existence of the illiquidity premium in bonds as well as stocks.

Yakov Amihud and Haim Mendelson, "Liquidity, Asset Prices and Financial Policy," Financial Analysts Journal, NovemberDecember 1991, pp. 56-66. "When designing an investment portfolio, a portfolio manager should consider not only the client's risk aversion, but also its investment horizon.  A short horizon calls for investing in liquid assets, whereas a long investment horizon enables the investor to earn higher net returns by investing in illiquid assets."

S. Brown, M.A. Milevsky, and T.S. Salisbury,
" Asset Allocation and the Liquidity Premium for Illiquid Annuities," Journal of Risk & Insurance, Volume 70 Number 3 (345kb). Here's an earlier version.  "...the required liquidity premium is an increasing function of the holding period restriction, the subjective return from the market, and is quite sensitive to the individual's endowed (preexisting) portfolio."

Elroy Dimson and Bernd Hanke, "The Expected Illiquidity Premium: Evidence from Equity Index-Linked Bonds," London Business School Working Paper, December 18 2002 (289kb). This paper found that: "There is an economically significant expected return premium associated with illiquidity."

Robert Novy-Marx, "On the Excess Returns to Illiqidity," CRSP Working Paper # 5555, April 8 2004 (85.1kb). This paper argues that the high expected returns observed on illiquid assets should be expected theoretically, but are not actually a premium for illiquidity, per se. Instead, illiquidity, like size, is a proxy for any unobserved risk. Liquidity should therefore have explanatory power in any asset pricing model that is not perfectly specified, with low measured liquidity forecasting high expected returns.

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