Liquidity risk premium (LP) refers to the additional return that investors require to hold an investment that is not easily convertible into cash or cannot be sold quickly without significantly affecting its market value. It is a compensation for the risk that investors take on by holding an asset that may not be easily traded, particularly during times of market stress or economic uncertainty.

Liquidity risk can arise from various factors, including market volatility, economic conditions, or changes in investor sentiment. For example, a bond that is illiquid may be difficult to sell in the market, especially during times of market turmoil, and may require a higher return to compensate investors for the added risk.

The liquidity risk premium varies depending on the type of asset, its liquidity, and the prevailing market conditions. Assets with lower liquidity tend to have a higher liquidity risk premium. Generally, investors demand higher liquidity risk premiums for longer-term investments as they are exposed to the risk of market fluctuations over a longer period of time.

In summary, the liquidity risk premium is the compensation demanded by investors for holding assets that may not be easily converted into cash or sold quickly.


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