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Page 1 of 5
In the long-term tremendous uncertainty exists and yet there are institutional
lenders that actively seek the long term. For example, pension funds and life
insurance companies that need to plan for exact financial obligations well into the
future, are not surprisingly, key players in the longer-term instruments arena.
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 2030 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 long-term 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 shortterm 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:
Implied Forward Rate (Year 2) =
Thus,
(1 + ti 2 ) 2
(1 + r ) t +1
I(r)t =
1 , or, I(r)2 =
1 , where
(1 + ti1 )
(1 + r ) t
I(r)t = Estimation of forward rates for time t
r = Interest rates
ti2 = Interest rates for time-period 2
ti1 = Interest rates for time-period 1
Page 2 of 5
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:
LP(t) =
(1 + rt +1 ) t +1
CS t
1
, where
(1 + rt )
(1 + rt )
CSt = credit spread of the lending organisation for each time period, a constant
From a transfer pricing standpoint, this argument is perfectly acceptable since every
time the liquidity premium is computed, the credit spread would reflect the current
creditworthiness of the specific rating grade, and therefore, the premium computed
would provide the most up-to-date view on the term structure of liquidity.
Page 3 of 5
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:
Risky
Curve (A)
Period
Implied Forward
Rate for (A)
Risk Free
Curve (B)
Implied
Forward
Rate for (B)
(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
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
31
4.930855
(2)
Difference
(1) - (2)
Credit
Spread
Liquidity
Premium
CS/(1+{B}1
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
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
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
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
0.00019124
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
3.446308168
4.622218
3.05827627
0.38803189
0.00019124
0.387841
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Graphically, the liquidity premium that could be used for pricing, margin
management, and transfer pricing, would be depicted thus:
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. This
essentially provides a singular view on the generation of term structures for liquidity
premiums that can be used for all purposes, including pricing, valuation, transfer
pricing and margin management.
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