Investing is about putting money at risk in order to earn a return. In theory, the more risk an investor is willing to accept, the more returns he or she should expect to earn to compensate for the risk.
Two metrics to quantify how the market is valuing risks and rewards are liquidity premiums and the real risk-free rate. In this post, we'll break down each.
An investment that can be sold quickly is less risky than an investment that cannot be sold as quickly at fair market value. For the harder-to-sell assets, called illiquid assets, an investor will expect a higher return to compensate for the risk of not being able to quickly turn that asset into cash.
The easiest way to calculate the liquidity risk premium for an investment is to compare two similar investment options, one being liquid and the other being illiquid. For example, you could compare two corporate bonds offered by similar companies with similar coupons and maturities, but one bond is publicly traded and the other is not. The bond that is publicly traded would be considered liquid, while the non-traded bond would be illiquid. The illiquid bond will have a lower price and higher yield to compensate investors for its higher liquidity risk. The liquidity premium would be the difference between the yields of these two bonds.
Another more general method for estimating the liquidity premium is to compare historic Treasury yields with current Treasury yields of similar duration. The difference in yields for the current Treasury and the average past Treasury yield for the duration of your investment is a decent indicator of the liquidity premium in the market today.
Real risk-free rate
The real risk-free rate takes the risk-free rate and incorporates inflation risk into the equation. Inflation is too often overlooked when assessing investment returns, but when high it can quickly erase actual wealth gains.
For example, if the stock market returns 8% in a given year but the inflation rate is 5%, the real return is a much less impressive 3%.
To calculate the real risk-free rate, subtract the current inflation rate from the yield of the Treasury bond that matches your investment duration. If, for example, the 10-year Treasury bond yields 2%, investors would consider 2% to be the risk-free rate of return. Treasury bonds are the most often cited proxy for the risk-free rate because they are backed by the full faith and credit of the U.S. government.
If inflation stands at 0.5%, then the real risk-free rate would be 1.5%: The risk-free rate of 2% minus 0.5% inflation equals 1.5%.
In practice, this 1.5% real risk-free rate is the rate that investors expect to earn after inflation from a risk-free investment with a 10-year duration after inflation.
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