Liquidty Risk Preimium

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Date Submitted: 09/01/2011 06:25 AM

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Before we start examining liquidity risk premium in the bond market, let us first understand what is exactly meant by liquidity. Liquidity is simply the gap between the fundamental value of a security and the price at which the security is actually transacted at; high liquidity means this gap is small and vice versa. Thus, liquidity risk is the uncertainty of how wide or narrow this gap will be at any point in time. For all investors and potential investors, liquidity risk is a real risk that they bear. Every transaction is essentially a negative NPV project for the buy-side investor. If the investor knew how negative the NPV would be, then this would not be a risk – the investor could simply perform his asset allocation optimization by factoring in the transaction costs.

There is strong evidence indicating that liquidity impacts asset returns due to the either individual security characteristics or as a systematic risk factor, motivated by previous empirical findings, present an equilibrium model with liquidity risk. Their Liquidity-Adjusted Capital Asset Pricing Model (LCAPM) captures multiple components of liquidity risk. Using U.S. stock market data, they show that their model is supported by the data.

The risk comes in not knowing how far off the investor will transact from the fundamental value of the asset he is buying or selling. Furthermore, this is a risk that is not fully diversifiable. The natural next question then is whether the systematic portion of liquidity risk is priced, i.e., do investors command a risk premium for bearing liquidity risk?

2. Introduction

Corporate bonds in India are traded within two distinct subgroups of investors, namely institutional investors (banks, foreign institutional investors and mutual funds) and non-institutional investors (known as retail investors). The risk-return relationship implicitly assumes that institutional and retail investors have uniform risk perceptions with regard to a specific...