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An important consideration with respect to the liquidity premium is that lenders have more flexibility with regards to the length of the lending period relative to borrowers. Many borrowers enter the long term market precisely because the nature of their project is long term. For these projects to be financially feasible the borrower needs to rely on a long continuous stream of revenues to repay the debt. Such projects are just not possible in a one to ten year horizon. Many home owners find that housing is affordable only if they can stretch the loan payments over a 20-30 year period of time given their annual income. Lenders, however, have a choice. A lender can make a loan for 5 years or that individual can make six sequential six-month loans. The 5 year loan locks in an interest rate for the duration of the loan at the prevailing long-term rate whereas the sequence of six medium-term loans exposes the lender to changes in nominal rates each time the funds are reinvested. The longterm loan exposes the lender to the uncertainty of distant future events in contrast to the medium term sequence which allows the lender to react to changing economic conditions. There is a balancing act taking place between uncertainty about future economic conditions and the direction of future interest rates. The liquidity premium will be directly influenced by expectations of future short-term rates. The actual derivation of liquidity and risk premia take place in financial markets through the process of buying and selling financial instruments, and this paper seeks to explore a methodology for the computation of a term structure for this premia. Implied forward computations of interest rates can be used as a starting point to arrive at the possible future rates that the lender may use to manage interest rate risks. Therefore:
Thus,
The difference between the implied forward rates in a risk-free curve and in a risky curve is a difference on account of the credit risk inherent in the lending and the term structure of the liquidity premium. Therefore:
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Obviously, the equation is flawed since the credit spread at time t is not a constant but changes according to the credit risk of the borrower, and therefore, the stipulated liquidity premium will not be a constant but a variable. To eliminate this problem, it can be stipulated that the risky curve is the curve that the lending organisation faces when it has a borrowing decision to make. In other words, we substitute the variable credit spreads value with a constant, which is the credit risk of the lending organisation, which makes this a constant across time-buckets, and for all counterparties, since this is the premium that the lending organisation will have to pay in order to borrow the funds if it were in need. The revised equation is now:
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Taking the sterling risk free curve and a triple A rated organisation as an example, the following term structure for the liquidity premium can be easily constructed:
Period Risky Curve (A) Implied Forward Rate for (A) (1) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 4.6695 4.841 4.9255 4.9675 4.9948 5.013915 5.0375 5.057686 5.070712 5.0775 5.080058 5.079879 5.077846 5.074461 5.07 5.064597 5.058311 5.051174 5.043216 5.0345 5.025128 5.01525 5.005047 4.99471 4.984422 4.974352 4.96464 4.955391 4.94667 4.9385 4.930855 0.05012781 0.152461834 0.213856986 0.275957793 0.341161144 0.410621923 0.483961542 0.560756229 0.640957432 0.724738834 0.812319521 0.903904237 0.999679491 1.099814759 1.204460819 1.313753272 1.427819438 1.546784412 1.670788194 1.799997282 1.934621892 2.074921224 2.221202596 2.373817125 2.533159663 2.699657803 2.873762805 3.055937192 3.246641132 3.446308168 4.229 4.416 4.535 4.606 4.64 4.653 4.687 4.706 4.721 4.751 4.777103 4.785314 4.776875 4.759578 4.742 4.729927 4.724944 4.725653 4.729311 4.733 4.734465 4.732521 4.726883 4.717862 4.706127 4.692517 4.677904 4.663076 4.648649 4.635 4.622218 0.04603336 0.14008984 0.19725285 0.25454632 0.31374175 0.37800019 0.44468296 0.51462118 0.59067617 0.67082225 0.75228616 0.8342171 0.91739842 1.00360882 1.09475296 1.19205944 1.29591278 1.40600586 1.52156911 1.64169084 1.76563119 1.89293109 2.02341944 2.15720216 2.29463016 2.43625581 2.58276102 2.73486712 2.89322371 3.05827627 0.00409445 0.01237199 0.01660414 0.02141147 0.0274194 0.03262173 0.03927858 0.04613505 0.05028126 0.05391658 0.06003337 0.06968714 0.08228107 0.09620594 0.10970786 0.12169384 0.13190665 0.14077855 0.14921909 0.15830644 0.1689907 0.18199014 0.19778315 0.21661496 0.2385295 0.263402 0.29100178 0.32107007 0.35341742 0.38803189 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.00019124 0.003903 0.012181 0.016413 0.02122 0.027228 0.03243 0.039087 0.045944 0.05009 0.053725 0.059842 0.069496 0.08209 0.096015 0.109517 0.121503 0.131715 0.140587 0.149028 0.158115 0.168799 0.181799 0.197592 0.216424 0.238338 0.263211 0.290811 0.320879 0.353226 0.387841 Risk Free Curve (B) Implied Forward Rate for (B) (2) Difference Credit Spread Liquidity Premium
(1) - (2)
CS/(1+{B}1
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Liquidity Premium
This approach takes into account the fact that borrowers are expected to pay a premium over and above the market price and over and above the spread the lending organisation chooses to incorporate as a measure of effective provisioning against bad and doubtful debts occurring. This approach models liquidity premium effectively as a spectrum by taking cognisance of the fact that as lending tenor increases, so does the premium. As can be seen from the table, even if the long term rates taper off, or indeed fall, the liquidity premium exhibits a rising structure. The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk: the notion that the future is more than a whim of the gods and that men and women are not passive before nature. Peter Bernstein, Against the Gods. The advantage of this approach is that it uses the same non-arbitrage theory for liquidity as has been used for pricing and valuation in the market risk world.
Suresh Sankaran is the Vice president and Director, Strategic Consulting Services, IPS-Sendero, UK.
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