Which of the followings is most likely to be true in describing the relationship between liquidity riskand bond yield relative to the Treasury bond? All else being equal, bonds that are:a) Less liquid have lower yield compared to Treasury bondsb) More liquid have higher yield compared to Treasury bondsc) Less liquid have higher yield compared to Treasury bonds
Question
Which of the followings is most likely to be true in describing the relationship between liquidity riskand bond yield relative to the Treasury bond? All else being equal, bonds that are:a) Less liquid have lower yield compared to Treasury bondsb) More liquid have higher yield compared to Treasury bondsc) Less liquid have higher yield compared to Treasury bonds
Solution
The correct answer is:
c) Less liquid have higher yield compared to Treasury bonds
Here's why:
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Liquidity risk refers to the risk that an investor might not be able to buy or sell bonds quickly enough in the market without affecting the bond's price. In other words, it's the risk that the bond cannot be sold at a fair price.
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Treasury bonds are considered the most liquid and safest bonds because they are backed by the full faith and credit of the U.S. government. Therefore, they have the lowest yield among all bonds.
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Other bonds that are less liquid than Treasury bonds have higher liquidity risk. To compensate for this higher risk, investors require a higher yield. This is known as the liquidity premium.
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Therefore, all else being equal, bonds that are less liquid have a higher yield compared to Treasury bonds. This compensates investors for the additional risk they take on when buying these less liquid bonds.
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