Certified Financial Management Specialist Practice Exam

What aspect of investment-related returns compensates investors for holding securities that are not readily marketable?

1. Default Risk Premium (DRP)

2. Liquidity Premium (LP)

3. Reinvestment Rate Risk

4. Maturity Rate Premium

The correct answer is: Liquidity Premium (LP)

The concept of the liquidity premium is designed to compensate investors for the risks associated with holding securities that are not easily sold or traded on the secondary market. When investors purchase securities that lack marketability, they accept a higher level of risk since they may face difficulties in liquidating these investments quickly without incurring significant losses. Liquidity premium arises because investors prefer assets that can be converted to cash rapidly at predictable prices. Hence, securities with lower liquidity tend to attract a higher return to compensate for the opportunity cost and potential loss that could arise if the investor needed to exit the investment quickly. This additional yield above the risk-free rate or the yield on more liquid assets serves as compensation for taking on that liquidity risk. The other options pertain to different types of risks associated with investments. Default Risk Premium pertains to the risk of a borrower failing to meet their repayment obligations, and it compensates investors for the credit quality of the issuer. Reinvestment Rate Risk involves the risk of having to reinvest cash flows at lower interest rates than the original investment, which can affect the overall return. Maturity Rate Premium is related to the additional yield required for taking on the risks associated with longer maturities, including interest rate fluctuations over time. Each of these concepts addresses specific risks