What is the liquidity premium in investment terms?

The liquidity premium in investment terms refers to the excess return required by investors for holding assets that are less liquid. Less liquid assets are those that cannot be easily bought or sold in the market without affecting their price significantly. Since these assets pose a greater risk of not being able to convert them to cash quickly or at a favorable price, investors demand a higher return as compensation. This premium serves as an incentive for investors to allocate their funds to these less liquid investments, accepting the potential for decreased accessibility to their capital in exchange for the opportunity for higher yields.

The other definitions do not accurately capture the essence of the liquidity premium. For instance, a penalty for selling liquid assets would imply a negative consequence for decisions involving assets that can be quickly sold, which does not align with the concept of a premium on less liquid assets. Similarly, stating that the return from highly liquid investments or the cost associated with maintaining liquidity does not address the concept that the liquidity premium specifically relates to the excess return required to hold assets that lack liquidity.