A country's economy dictates many factors, including how businesses or investments perform. Therefore, it is crucial for investors to consider these factors to make well-informed decisions. For that, they need to identify some economic indicators. However, it is crucial to understand what economic indicators first.

What are Economic Indicators?

Economic indicators are metrics that measure and analyze current or future investment possibilities. By doing so, they look at a nation's health of macroeconomy. For investors, these indicators are crucial as they dictate the systematic risk that affects their investments. There are many economic indicators that may exist, usually categorized into several categories.

The primary economic indicator for any nation is its gross domestic product (GDP). It is a type of coincident indicator. Apart from GDP, consumer confidence index, consumer price index, new housing starts, money supply, personal income, etc., are economic indicators examples. All of these measures a nation's economic health based on the timing of fluctuation in economic activity.

What are Lagging Economic Indicators?

Lagging economic indicators are any economic indicators that measure fluctuations in economic activity after they occur. It is why it gets the name 'lagging', as it does not indicate changes until after they happen. For most investors, lagging economic indicators are a method to look at historical performances. However, these indicators are not beneficial in predicting future economic outcomes.

Lagging economic indicators are quantifiable metrics. However, they only change once the associated economic or financial variables change. These indicators benefit investors as they allow investors to establish a trend in a nation's economic activity. Based on that, they can make decisions related to their investments.

Lagging economic indicators also have other uses. They are helpful tools in business operations and strategy. These indicators usually confirm patterns that occur over time. They also help identify when there is a change in a country's business cycle. Some investors may consider lagging economic indicators to be futile. However, used with other economic indicators, lagging economic indicators can be significantly beneficial.

What are the types of Lagging Economic Indicators?

There are several economic indicators that classify as lagging. These indicators only identify economic activity fluctuations after they occur. Therefore, they fall under the lagging economic indicators category. Some of the types of lagging economic indicators are as below.

Unemployment

Unemployment is one of the primary types of lagging economic indicators. It is when people in an economy lose their jobs. Unemployment also stems from not having enough jobs while workers are available. Unemployment exists during all stages of a business cycle.

Consumer Confidence Index

Another lagging economic indicator that people consider is the Consumer Confidence Index. It measures people's attitude toward the economic conditions prevalent in a country, whether future or current. This index represents people's trust in the economic conditions.

Gross National Product (GNP)

The gross national product is also a lagging economic indicator. It represents an estimate of the total value of all final products and services produced by the residents of a specific country. It differs from the GDP, which does not require the product to be from residents.

Conclusion

Economic indicators measure a country's economic health. These are beneficial for investors to base their decisions. There are several types of economic indicators. Lagging economic indicators only measure economic events after they occur. These may include the unemployment rates, consumer confidence index, gross national product, etc.

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Several theories or models explain how economics works. These models usually seek to explain any relationships between economic principles. However, most of them are theoretical. They do not consider actual quantifiable statistics. However, it is still possible to quantify some economic phenomena, usually through econometrics.

What is Econometrics?

Econometrics is a term in economics used to describe using mathematics, statistics, and economic theory to quantify economic phenomena. It works by using data to develop economic theories. Similarly, it helps test them to establish trends or relationships between historical data. Econometrics allows for the quantitative analysis of actual economic phenomena based on the concurrent development of theory and observation.

The term econometrics comes from a Polish Economist Pawel Ciompa in 1910. However, it only became relevant in 1969 after the work of Ragnar Frisch and Jan Tinberg. Their work defined the term and set the path for future use. There are several tools within econometrics that economists can use. As mentioned, these tools use mathematical statistics and statistical theory to evaluate and develop economic hypotheses.

How does Econometrics work?

Econometrics uses both statistical and mathematical theories to test economic phenomena. It combines statistics, mathematics, and economic theory to quantify any data. Using econometrics, economists can help describe relationships between economic phenomena. In short, econometrics tests economic theories by using quantifiable data. Using this, economists can also establish trends that can be useful in forecasting.

Econometrics starts by obtaining a set of data that correlates to a specific economic theory. Once users do so, they need to analyze the data. Then, they can use various econometrics tools to establish a relationship between the data. Usually, it may involve determining a linear relationship. However, users can also use complex tools to include multiple variables.

What are the tools used in Econometrics?

Economists can use several tools as a part of econometrics. These may include time-series analysis or regression analysis. Furthermore, it consists of multiple linear regression. Some other econometrics tools include linear programming, correlation, and regression, simulation equation, frequency or a probability distribution, etc.

These tools can help economists apply econometrics in their work. While most of these are possible to use through calculations, economists can also use software packages. However, the results may differ from one dataset to another based on several variables. Economists also need to make certain assumptions during their calculations, which can affect the results.

What is the importance of Econometrics?

Econometrics is important in economics for several reasons. Most importantly, it helps economists test theories or hypotheses, whether existing or new. On top of that, they can convert data into a specific model to make decisions that support empirical data. Econometrics allows economists to convert economic theories into quantifiable metrics.

Econometrics is also crucial for establishing trends between datasets. Based on these trends, economists can also forecast future financial or economic trends. It also helps them get a specific pattern or result from cluttered data. Usually, economists can use prepackaged software that allows for straightforward analysis.

Conclusion

Economics includes theories or models, which are usually qualitative statements. By using econometrics, economists can convert them into quantitative statements. Econometrics uses statistics, economic theories, and mathematics to test economic phenomena. It is of high importance for several reasons, as discussed above.

Originally Published Here: What is Econometrics And Its Importance?

Gross Domestic Product (GDP) represents an estimate of a country’s total value of finished goods and services. It considers these goods and services over a specific period, usually every year. Overall, GDP is an indicator of a country’s total economic activity. High GDPs represent higher production of goods and services.

For some countries, GDP may remain constant or have minimal movement over a period. These usually include developed or stable countries. For others, however, the GDP rate may fluctuate significantly. Usually, these consist of emerging markets or countries. Before understanding emerging market GDP growth, it is crucial to understand what emerging markets are.

What is an Emerging Market?

Emerging markets are economies that have similar characteristics as developed economies. However, some factors prevent their classification as a developed economy. In emerging markets, the per capita income is low to medium. These nations also become a part of the global market with their growth. There are several characteristics that emerging markets exhibit.

In emerging markets, the trading volume usually grows. Similarly, the economy attracts investors from around the globe. One reason for this is the increase in the liquidity of both equity and debt markets in the nation. However, these countries still need regulations. One characteristic of emerging markets is the development of enhanced financial regulations. It, in turn, helps investors gain more confidence in its investment markets.

How do Emerging Markets work?

There are no specific requirements for a nation to be an emerging market. Usually, however, countries that go through significant positive economic changes may qualify as emerging markets. One feature that these countries exhibit is simulating developing countries. However, these changes are unquantifiable. Instead, most experts look at the economy’s GDP growth to establish whether it classifies as an emerging market.

There are several characteristics that differentiate emerging markets from others. Usually, if a country exhibits these characteristics, it may classify as an emerging market. The primary feature of these markets is low or medium per capita income. Usually, this income is lower than average. It occurs because of rapid growth in the economy.

Emerging markets also illustrate high volatility. It comes due to the rapid social changes that occur in the economy. Similarly, the country's currency exchange rates may also fluctuate rapidly due to it. Despite these, emerging markets experience active economic growth. On top of that, these countries have a substantial potential for growth in the future as well.

What is Emerging Market GDP Growth?

GDP growth represents the difference between a nation's GDP over a specific period. The GDP growth rate for most emerging markets has been over 4%. This rate is higher than the GDP growth rate for developed countries, which stayed low at 2%-3%. Among the emerging markets, countries in Asia showed the best GDP growth.

In Asia, the two largest emerging markets are India and China. These two countries are responsible for over 35% of the world's population and labour force. Outside Asia, countries such as Brazil and Russia are on top of the list. These four countries also account for 30% of global production. Together, emerging market economies make up almost 70% of the world's total GDP growth.

Conclusion

Emerging markets include countries that show similar characteristics as developed nations. These countries are in the process of undergoing a substantial change. The emerging-market GDP growth rate is usually 4% or above.

Originally Published Here: Emerging Market GDP Growth

Interest rate defines the rate at which a borrower pays interest on a loan's principal amount from a lender. Every loan transaction will include an interest rate. For borrowers, lower interest rates are preferable as it means they have to bear lower expenses. On the other hand, lenders will prefer their interest rates to be higher as it suggests they will get higher returns.

Usually, the lender decides the interest rate on a loan transaction. They consider various factors while establishing the percentage. Most importantly, lenders account for their risks for any loan transaction by setting the interest rate. Interest rates are generally positive. In some instances, however, they may also be negative. Negative interest rates may sound impossible, but it is still possible.

What is a Negative Interest Rate?

Negative interest rates occur due to a country's monetary policies. Usually, a country's central bank dictates these policies. Therefore, the bank may, in some circumstances, set the interest rates to be negative. While these cases as rare, they may still occur. With negative interest rates, the central bank can decrease the borrowing cost prevalent in the economy. Through this, the bank can increase economic activity.

Negative interest rates sound counterintuitive. While these may be costly to the government, they can also be beneficial. Negative interest rates allow the central bank to control the economy during economic recessions. Usually, it causes investors to obtain loans and use them towards investments. Similarly, people may use loans for other activities, which generally increases the consumption in the economy.

How does a Negative Interest Rate work?

With usual interest rates, a lender provides a borrower with a loan. After a predetermined period, the borrower pays interest to the lender. This interest depends on the interest rate set on the transaction. However, the same does not apply to negative interest rates. After the predetermined period, the lender pays the borrower interest.

Therefore, with negative interest rates, borrowers actually earn income rather than bear expenses. The lender, on the other hand, suffers expenses related to the interest rate. As mentioned, however, the lender, in this case, is the government or the central bank. These entities usually have other benefits they receive from paying interest on the loans they provide.

During specific circumstances, such as recessions, people usually accumulate money. They refrain from investing or spending the money. It causes the aggregate demand in the economy to decline. During these periods, the central bank can use negative interest rates to encourage investments. This strategy is a part of the monetary policy.

What is the impact of the Negative Interest Rate?

The negative interest rate encourages most commercial banks to borrow more. It is because they can earn on these loans. In turn, these banks also decrease the interest rates in the market. The lower or negative market interest rates attract more investors and individuals to obtain a loan. Through investments and spending, they contribute to the country's economic activity.

The above is the intended impact of a negative interest rate and can lead to increased aggregate demand. Apart from that, the negative interest rate may also affect a country's economy. Negative interest rates also influence the forex exchange rate. Due to the decrease in interest rates, a country's currency value falls. This devaluation can promote export activities in the country.

Conclusion

Interest rates are the percentage that lenders charge on their loans. In some cases, these rates may be negative as well. Negative interest rates are a part of a country's monetary policy, dictated by its central bank. With these rates, borrowers can earn interest income rather than bear expenses. A negative interest rate can have several impacts, as discussed above.

Originally Published Here: Impact of Negative Interest Rate

A country's monetary policy defines the policies its central bank employs to control its money supply. Usually, the bank does so to achieve macroeconomic goals. In this process, the central bank manages the growth and volume rate of the money supply in the economy. There are several steps involved in establishing a monetary policy for a country.

The primary control source using the monetary policy is money supply and interest rates. Using these, the central bank can also dictate other factors such as the country's growth, consumption, and inflation rates. There are several strategies that the central bank can use when establishing a monetary policy. One such policy is quantitative easing. However, it is not as prevalent as other techniques.

What is Quantitative Easing?

Quantitative easing is a strategy used by a country’s central bank when establishing a monetary policy. The bank acquires long-term securities from its member banks. By doing so, the central bank releases money into the economy. This technique causes the interest rates in the economy to fall. Therefore, it increases the money supply to decrease interest rates.

Unlike some other techniques, quantitative easing isn't as prevalently used by the central bank. It is considered a non-traditional policy. Quantitative easing aims to encourage investment and borrowing by decreasing interest rates. On top of that, it provides banks with better liquidity. Some central banks may utilize quantitative easing to lower their fund rate to zero.

How does Quantitative Easing work?

When establishing a country's monetary policy, a central bank can use several techniques. With quantitative easing, the central bank picks all government securities from its member banks. These may include commercial banks or even private financial institutions. Through this, the central bank releases a money supply into the economy, causing a decrease in short-term interest rates.

The decline in short-term interest rates encourages individuals to borrow funds. Similarly, the prices of financial assets in the market also rise, further benefiting investments. Since the member banks receive a money stream, they can use it to increase their lending activities. As a result of the increase in money supply, the interest rates decrease.

On top of that, quantitative easing can also have other benefits. One of these comes from its effect on the country's currency. As this technique keeps the currency's value low, it also makes investments attractive to foreign investors. Similarly, the exports increase as the lower currency value makes it a viable option. Overall, quantitative easing can have several impacts on a country’s economy.

What are some limitations of Quantitative Easing?

While quantitative easing can be significantly beneficial, it also comes with some limitations. Firstly, it relies on member banks to reuse the money supply for lending activities. Some banks may, however, choose to invest this amount instead. While it may be beneficial in other ways, it does not achieve the objective of quantitative easing.

Similarly, quantitative easing requires governments to control and overlook the process. If the central bank causes a sudden increase in money supply, it may have detrimental effects. Furthermore, while this technique can increase imports, it may also damage the country's import industry.

Conclusion

A country's monetary policy dictates its money supply and interest rates. Usually, the central bank is responsible for setting this policy. One technique they can use for monetary policy is quantitative easing. Quantitative easing allows the central bank to acquire long-term securities from its member banks. By doing so, it releases the money supply while also decreasing interest rates.

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Inflation is a term used in economics to represent increasing goods and services prices. Similarly, it signifies a decline in a currency's purchasing power. Inflation can be good or bad, depending on various factors. There are two terms associated with inflation that people often confuse. These include deflation and disinflation. While they may sound similar, both are different from each other.

What is Deflation?

Deflation represents a decline in prices for goods or services over a specific period in an economy. It also entails the increase in a currency’s purchasing power. Deflation is when an economy experiences no inflation. Instead, it goes through a period when the inflation is negative. That is why another name used for deflation is negative inflation.

There are two factors that contribute to deflation in an economy. These factors come under two categories. These include a fall in aggregate supply and aggregate demand. In both these cases, the consumption in an economy decreases. It then causes item prices to fall. Some consumers stop spending during this period as they may expect item prices to decline even further.

What is Disinflation?

Disinflation does not represent negative inflation in an economy. Instead, it signifies a decrease in the inflation rate in the economy. It often portrays events when the inflation rate in an economy reduces marginally over a relatively short period. In simple terms, disinflation represents the rate of change in the inflation rate rather than the direction in which it fluctuates.

Disinflation, unlike deflation, does not have the same adverse characteristics. It is because it does not cause item prices to decrease or purchasing power to increase. It also does not indicate an economy is slowing down. Disinflation is a relative term that describes the change from inflation from one period to another.

What is the difference between Deflation and Disinflation?

There are several differences between deflation and disinflation. These are as below.

Definition

The primary differences between deflation and disinflation come from their definitions. As mentioned, deflation represents negative inflation. On the other hand, disinflation signifies a reduction in the inflation rate over a period.

Impact

Deflation can have adverse impacts on an economy. It usually causes higher unemployment, lower production, lesser economic activity, etc. On the other hand, disinflation does not have the same impacts as it is not negative inflation. Instead, it carries all the effects of inflation but at a slower rate.

Frequency

Deflation is relatively rare compared to disinflation. It is because the prices for goods and services seldom decrease compared to previous periods. However, disinflation is more common.

Countermeasures

Deflation can cause countries to suffer from a recession or even a depression. Therefore, most economies use countermeasures to safeguard against such effects. On the other hand, disinflation is not concerning for governments. Therefore, there are no countermeasures against it.

Consumer behaviour

Deflation can adversely impact consumer behaviours. As mentioned, consumers usually refrain from spending money due to deflation. It further amplifies the existing issues. However, the same does not apply to disinflation. Most people don't even notice it. Therefore, there is no change in consumer behaviour due to disinflation.

Conclusion

Inflation represents the increase in the prices of goods and services in an economy. Two terms associated with it include deflation and disinflation. Deflation is the negative inflation in an economy. However, disinflation signifies a decrease in the inflation rate. Both are different in several regards, as mentioned above.

Originally Published Here: What Is The Difference Between Deflation and Disinflation?

A nation or region's economy may go through many fluctuations over a defined period. Usually, countries experience positive changes, which increases employment, production, demand, etc. Sometimes, however, some countries may also go through adverse changes. These changes have the opposite effect. These fluctuations represent the country or nation's business cycle.

In almost every situation, countries will prefer to go through a positive expansion period. It is because this period promises better circumstances for businesses, individuals, and all participants in an economy. However, these periods also follow a recession, which is inevitable most of the time. However, a recession isn't necessarily bad. Before understanding whether a recession is good or bad, it is necessary to define it.

What is a Recession?

A recession is a term in economics used to describe a significant decline in a country's economic activity. Usually, experts consider two consecutive quarters to establish whether a country is in a recession. During these periods, the country suffers from a decline in economic activity, also reflected in its Gross Domestic Product (GDP). However, there are some instances where economies have not suffered from a recession despite two consecutive economic downfall quarters.

In general, a recession represents a widespread decline in economic activity over several months. It differs from a depression that lasts over several years. Multiple recessions can cause an economy to go into a depression. Usually, recessions occur after the GDP growth in a region slows down for several quarters before it becomes negative.

There are several indicators of recession. These include lower employment rates, GDP downfalls, falling asset prices, lowering production, etc. However, more deeply, it comes due to a loss of business or consumer confidence. When either party stops having confidence in the future, business activity goes down. It further causes all the problems mentioned above.

Is a Recession good or bad?

Recession can be good or bad depending on several factors. As mentioned, there are several factors that determine whether a nation is going through a recession. Most of these factors cause an adverse impact on the country's economic activity. For that reason, most people consider recession to be bad. On top of that, as mentioned above, a recession can lead to depression. It also further signifies why a recession is bad.

In most markets, recessions cause a decline in asset prices. Therefore, investors may suffer due to prolonged recession periods. It is also difficult for them to dispose of their assets during this period. The country's currency also loses its value, which can further exaggerate the problem. On top of that, consumers also generally refrain from buying new goods or using services. This way, the economic activity in the country declines even further.

In some cases, a recession may also be good. Some businesses thrive under a recession, which can help the country and its economy. Similarly, efficiencies rise in markets, which can have a positive impact on production and consumption. Recessional periods are also well-known for giving rise to new ideas, leading to increased economic activity. Despite that, the adverse impacts of a recession usually exceed the positive effects.

Conclusion

A recession represents two consecutive downfalls in a country’s economic activity. There are several factors that indicate a recession. These may include lower production, increasing unemployment, lower consumption, etc. Most of these signify that recession is bad. However, there are some circumstances in which recession can be good as well, as mentioned above.

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Investors need a diversified portfolio to mitigate any systematic or unsystematic risks. For that reason, they will include a variety of investments in their portfolio. While investing in the stock and bond market is common for most investors, they may also look towards the housing market. The housing market, however, does not perform similarly to the stock or bond market.

The housing market does not suffer regular fluctuations compared to other markets. However, there are times when this market takes a hit. Historically, the housing market has not suffered an impact due to economic downturns. Several factors may contribute to it. Nonetheless, the housing market may experience some changes during a recession.

What is a Recession?

A recession is a period when there is a significant downturn in economic activity in a country or region. Usually, recessions follow consecutive periods of economic decline. During a recession, the economic activity in a nation declines. There are several factors that may indicate a recession. These include higher unemployment, lower incomes, falling interest rates, lower industrial production, etc.

Most experts suggest that when a country enters into a recession, its GDP shrinks for two consecutive quarters. However, there is evidence that suggests that might not be true. Nonetheless, a recession occurs when a region or country experiences continuing economic downturns. For example, a nation that goes through several periods of deflation may enter into a recession.

What is the relationship between a Recession and the Housing Market?

There is no conclusive evidence that suggests a direct relationship between recession and the housing market. The actual connection between these two may depend on several factors. Recession may not actually be bad for the housing market. During a recession, the market interest rates fall. It means that investors can obtain loans at a lower interest rate and invest it in the housing market.

Falling interest rates also means that investors have to pay lower mortgage payments. Therefore, they can actually afford to pay their mortgage even when they don’t have a steady income source. However, this advantage only applies to new homeowners. For those who have already invested in the housing market, it may be a different story.

For existing homeowners, a recession can be significantly detrimental. They suffer due to the decreasing house prices. On top of that, they have to pay higher interest rates on their mortgages because they obtained the loan before the recession. As mentioned, however, that may not be the case for every recession. Sometimes, existing homeowners may also benefit from an appreciation of home values.

Should investors invest in the Housing Market during a Recession?

Historical data suggests that a recession is the best period for investing in the housing market. As mentioned above, it is because the interest rates are lower during this period. For investors, the housing market is a stable investment market during a recession. However, obtaining such facilities may not be possible for everyone.

Another issue for investors to consider is whether they can dispose of their assets during a recession. Therefore, they will need to account for the illiquidity that comes with such investments. Overall, a recession has minimal or no impact on the housing market. Therefore, it presents a valuable investment for most. As mentioned, however, some factors may suggest otherwise.

Conclusion

A recession is a period of consecutive downfalls in a country or region's economic activity. The housing market is often a stable investment for most investors during this period. However, it may also impact existing homeowners adversely. Nonetheless, several factors dictate whether a recession will impact the housing market.

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Investors have to consider various factors when contemplating the decision related to an investment. Usually, the main aspects they take into account are the risks and returns they get from it. However, other factors also play a role in their decision-making process. One of these includes the timing of the returns and initial investment made.

For most securities, the maturity period defines the time when investors can get their initial investments back. The longer this period is, the more investors have to wait. It also means that investors can't use their invested money for other projects or investments. Therefore, investors need compensation for investing their money for prolonged periods of time.

What is Maturity Premium?

Maturity premium, also known as maturity risk premium, is the compensation investors expect for investing in securities with late maturity dates. Usually, maturity risk premium entails two types of risks, including interest rate risk and reinvestment risk. The longer investors hold an investment, the higher these risks will be. Therefore, for long maturity period investments, investors will require a higher maturity premium.

In short, the maturity risk premium for investment increases with an increase in the time to its maturity. Investors can calculate the maturity premium for specific security by comparing it with identical securities. The maturity risk premium will depend on the difference between each securities maturity period. Usually, maturity premium applies to debt instruments, such as bonds.

Maturity premium applies to all long-term securities. Most of these instruments carry higher interest rates, which is due to the extended maturity period. The market premium also plays a role in establishing bond prices. It is because the price of a security or investments carries higher fluctuations due to fluctuating market interest rates.

How to calculate the Market Premium?

Investors can calculate the market premium, as mentioned above. However, this calculation is merely an estimate and does not measure the market premium accurately. As stated above, the longer the maturity period for security is, the higher the market premium will be. Therefore, securities with a 5-year maturity will carry a lower maturity premium than 3-year securities.

Investors can use the following market premium formula to estimate the market premium for security.

Market Risk Premium = Yield_n+m - Yield_n

In the above formula for maturity premium, Yield_n+m represents the yield on a bond with a maturity of n+m. Yield_n, on the other hand, represents the yield on a bond with n years maturity. As mentioned above, these bonds need to be identical.

Why is the Maturity Premium important?

The maturity premium is important for investors as they can get higher returns on longer maturity investments. It is because these investments lose value before they reach maturity. Therefore, investors need compensation to cover this risk. It also helps companies and other issuers in securing finance for prolonged periods.

Investors also face other risks associated with these investments, including the interest rate risk and reinvestment risk. Both of these can be detrimental to investors. Therefore, they need the market premium to cover these risks. Overall, the market premium provides investors with an extra incentive to invest in long-maturity securities.

Conclusion

Investors face various risks when investing in long-maturity investments. Therefore, they need to get compensation for it. The maturity premium is any additional payment that investors can get on long-maturity investments. It is important for both the issuer and the bondholder, as stated above.

Originally Published Here: What is Maturity Premium

Investors need to weigh in various factors when evaluating private companies. These may include the company’s book value, its profits, its cash flows, etc. Usually, public companies are easier to evaluate since most of the information is available through the stock market. However, the same does not apply to private companies. On top of other factors, investors also need to consider the illiquidity premium for these companies.

What is Illiquidity?

Illiquidity is a term that refers to the state of securities that investors cannot readily convert into cash. Illiquidity is the opposite of liquidity, which specifies how easy it is for investors to exchange assets for cash. The more liquid assets are, the easier it is for investors to get cash in exchange. However, illiquidity is the opposite. The more illiquid assets are, the more difficult it becomes for investors to exchange them for cash.

Illiquidity is highly crucial for investments as they are riskier compared to liquid assets. These assets have lower demand due to that reason. Similarly, illiquid assets experience more price volatility compared to liquid assets. The lack of high-volume market trading also contributes to the illiquidity of these assets. Despite that, investors may invest in illiquid assets for the illiquidity premium they can get on them.

What is the Illiquidity Premium?

The illiquidity premium is the returns that investors expect to get from illiquid investments above the market average. While the illiquidity premium may sound negative, it represents the higher returns investors get from illiquid assets. Therefore, it can be a positive thing for investors. The higher the illiquidity premium on investment is, the more investors will make from it.

Illiquidity premium only applies to illiquid assets. These usually include real estate or private company stocks. These assets are not as liquid as other options. Despite that, these offer higher returns than some liquid assets. These higher returns represent an incentive for investors that invest in illiquid assets. As mentioned, however, these also come with higher risks that investors have to take.

With illiquid investments, investors have to tie up their money for a long time. During this time, they can make income on other investments that are liquid. Since investors choose to invest in these illiquid assets, they expect these assets to provide higher returns than liquid investments. Therefore, they look at the investment’s illiquidity premium to determine how much returns they will generate.

What is the Illiquidity Premium for Private Companies?

As mentioned above, investing in private companies is usually more complex compared to public companies. Due to the low trading volume for these companies, their stocks are highly illiquid. However, some private companies offer higher returns compared to public companies. For investors, this represents the illiquidity premium for private companies.

However, quantifying the illiquidity premium for private companies is complex. Nonetheless, investors can use it to evaluate private companies. Investors can add the illiquidity premium to the cost of equity for a private firm. They can use it to compensate for the risks associated with investing in private companies. This premium will differ for each private company.

Conclusion

Investors prefer to invest in liquid assets. Liquidity represents how easy it is for investors to convert assets into cash. On the other hand, assets that investors can't readily exchange for cash are illiquid assets. Illiquidity premium is the returns above the market average that investors expect to make on these assets.

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