What does the liquidity premium represent?

The liquidity premium represents the additional yield that investors demand for holding assets that are less liquid compared to more liquid assets. This premium compensates them for the increased risk and potential cost associated with not being able to quickly convert the illiquid asset into cash or sell it in the market without incurring a significant loss.

Illiquid assets can include items such as real estate, investments in private companies, or certain bonds, which often require time to sell and may not have a ready market. As a result, investors will seek a higher return on these types of assets to reward them for taking on the added illiquidity risk. This higher yield acts as an incentive for investors willing to tie up their capital in less liquid investments, making it clear why the liquidity premium corresponds specifically to the yield for holding these illiquid assets.