what does it mean to capture a premium such as an illiquidity premiums ? if an asset is relatively illiquid and is therefore priced at accordingly. why should i buy it in order to capture the premium. anyone explain ?
I guess if has to do with efficient markets and with risk premiums. Illiquidity = risk, and you should be compensated for taking risk, so expected return should be higher. I know it sounds confusing when you se this in a different context (as for example valuation discounts because of illiquidity and things like that), but overall the “capture the premium” has to do with higher expected returns you know, if this illiquid thing does not compensate with a higher expected return… why buy it?
if the asset is being discounted for being illiqiuid how do we achieve the expected return commensurate with that higher risk ?
think of a thinly traded zero coupon bond, that should be trading at 80%, with 5 years to maturity. Expected return = 100% (at maturity) - 80% = 20% ok, as it is very very very very illiquid, the bond is actually trading at 65%. Expected return = 100% (at maturity) - 65% (current price) = 35% I know is very simplistic, but I think that is the idea behind
So in other words for illiquidity premium to be realized other market forces would come into play. Supply/ Demand etc ?
seems so, although perhaps you can find situations where that is not necessary for example, small banks with high demand of cash can offer prospect clients deposits at above-market interest rates with the condition that the clients can not unwind the deposit during the whole life of the transaction Actually, in this case, as illiquidity is so severe (actually, there is no liquidity), they compensate with a higher than normal yield again, too simplistic, but just an example
the bank example I understand because it is part of the structure of the product. I am thinking more about other asset classes …eg real estate
the other concept related this is I guess the cost of providing liquidity …
Basically, if the item were liquid, more people would want to buy it, so the price goes up and, other things equal, it brings the return down. Now, if the item is illiquid, a number of investors will stay away from it, because they have individual circumstances or IPS statements that mean this is not something they should invest in (because they need liquidity). This means that fewer people will demand the asset and the price will drop. However, this doesn’t mean that the illiquid asset will produce any less, so that means that, other things equal, the return will be higher than an otherwise identical asset that is more liquid. Another way to look at it is that if you had two assets that returned the same, but one could be sold whenever you needed it, and the other could only be obtained 5 years from now, you’d probably just go with the liquid asset. To get you to buy the illiquid one, you’d need to have some higher rate in order to compensate you for having to lock it up for 5 years. If you need to sell an illiquid asset suddenly, you may not be able to do it at all. And if you can sell, you will generally risk having to take a substantial discount (which effectively provides whoever you are selling it to a built-in premium for providing liquidity). So, for example, suppose there is a panic in some asset like CDOs, which freeze up because no one wants the stuff. You can provide liquidity by buying them, and you’ll get the CDOs at a discount for doing so. Most of the time, people think of it as value investing, getting something for cheap, but if the reason is that markets are dumping and need to find buyers, it is effectively a liquidity premium you are capturing for providing liquidity.
Very clear now. Thanks @ bchadwick