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Set the premiums paid for bearing illiquidity risk against each other, both across asset categories and within a single category.

FRM® Part II · Risk Management and Investment Management · Illiquid Assets · FRM2.IM.17.e

The idea

An illiquidity premium is the extra expected return an asset must offer over an otherwise identical liquid asset. It compensates for trading costs and for the risk of being unable to sell when cash is needed. Within a category the comparison is clean. Off-the-run Treasuries yield more than on-the-run ones, and illiquid stocks and bonds earn more than liquid peers with similar risk. Across categories it is harder, because private equity, real estate and hedge funds also differ in leverage, factor exposure, credit risk and measurement bias, so raw return gaps overstate the pure premium. The premium per unit of illiquidity tends to be smaller for illiquid assets, because long-horizon investors who trade rarely spread the cost over many years and accept less. The exam point: strip out other risks and biases before calling a return gap an illiquidity premium.

A practice question

From the question bank, with the reason each wrong option is wrong.

Within the Treasury market, which comparison best illustrates an illiquidity premium inside a single asset category?

  1. Off-the-run Treasuries tend to yield more than comparable on-the-run Treasuries. - correct
  2. On-the-run Treasuries tend to yield more than comparable off-the-run Treasuries.Why not: Reverses the premium: the more liquid on-the-run issue commands the higher price and lower yield.
  3. Treasury bills yield more than Treasury bonds of the same issuer.Why not: This reflects the term premium and the yield curve, not liquidity.
  4. Treasuries yield more than corporate bonds of similar maturity.Why not: Corporate bonds usually carry extra credit and liquidity compensation, so Treasuries yield less.

The on-the-run issue is the most actively traded and so is priced richly. The off-the-run issue has similar cash flows but trades less, so it must offer a higher yield.

A harder one

Asset X has a round-trip transaction cost of 2.4 percent and is held by an investor for 3 years. Asset Y has a round-trip cost of 5.0 percent and is held by a different investor for 10 years. The annualised transaction cost of Asset Y for its holder is closest to:

  1. 5.00 percentWhy not: Ignores the holding period and uses the full round-trip cost as an annual cost.
  2. 0.50 percent - correct
  3. 0.25 percentWhy not: Halves the round-trip cost as if it were one-way, as well as spreading it over 10 years.
  4. 1.67 percentWhy not: Spreads Y's cost over X's holding period of 3 years.

Annualised cost = 5.0 / 10 = 0.50 percent, below X's 2.4 / 3 = 0.80 percent. Long-horizon holders spread costs over more years, so assets that are costlier to trade can need only a modest premium.

The hardest tier

Assume Treasuries return 4.0 percent, liquid corporate loans 5.5 percent with expected default losses of 0.6 percent, and illiquid private loans 8.0 percent with expected default losses of 1.2 percent. All other risks are the same for the two loan types. The illiquidity premium of private loans over liquid loans is closest to:

  1. 2.5 percentWhy not: Compares the raw returns of 8.0 and 5.5 without adjusting for the different expected losses.
  2. 4.0 percentWhy not: Compares private loans with Treasuries, which mixes in credit compensation and not only illiquidity.
  3. 1.3 percentWhy not: Deducts only the private loans' expected loss from the raw gap and not the liquid loans' expected loss.
  4. 1.9 percent - correct

Net of expected losses, private loans earn 8.0 - 1.2 = 6.8 percent and liquid loans earn 5.5 - 0.6 = 4.9 percent. The premium is 6.8 - 4.9 = 1.9 percent.

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