Liquidity & Expectation Hypos

#liquidity risk premium & #unbiased expectations hypothesis.

Money can be discussed as a negative NPV asset because it does not yield interest income, while on the other hand, it can be discussed as an option on positive NPV investment or as a hedge against adverse movements in cash flows.

Consequently, there always exists some optimal level of liquidity provision (although a specific theory defining this equilibrium is yet to be established).

The integration of “liquidity risk premium” into the “unbiased expectations hypothesis” further confirms the superiority of liquidity assets.

Recall – according to the unbiased expectations theory, there is a determination of the dynamics of interest rate expectations, based on short-term and long-term bonds’ spot rates. A more refined version of this theory is known as the Liquidity Premium Theory, where the liquidity component is added to the formulas.

Below, the graph illustrates the difference between the differentiated cash flows obtained from these two theories. The shaded area represents the addition of the liquidity component.

It is essential, for intuitive understanding, to consider liquidity risk in two parts:

Firstly, – some bonds or stocks do not trade on the exchange and are thus less liquid. As a result, the market demands a higher risk premium (i.e., a lower price for the asset) in other market conditions.

Secondly, the longer the bond’s duration, the higher the liquidity risk because the price of the asset is more sensitive to interest rate movements. Consequently, the liquidity component increases significantly in relation to the probability of cash flows. (This is also the case in practice – the return on short-term bonds is significantly higher than on long-term ones).

Source:

Financial Markets and Institutions – by A. Saunders, M. Cornett & O. Erhemjamts