Certified Financial Management Specialist Practice Exam

What is the extra yield associated with securities that are not easily convertible to cash?

1. Liquidity Premium (LP)

2. Maturity Rate Premium

3. Reinvestment Rate Risk

4. Default Risk Premium (DRP)

The correct answer is: Liquidity Premium (LP)

The extra yield associated with securities that are not easily convertible to cash is known as the Liquidity Premium (LP). This premium compensates investors for the risk of not being able to sell the asset quickly or without a significant loss in value. When securities are illiquid, investors demand a higher return as a form of compensation for the additional risk and potential difficulties they may face in converting those securities into cash. Investors generally prefer to hold liquid assets because they can be sold quickly, especially during times of market stress or personal financial need. The inclusion of a liquidity premium reflects that preference, thus raising the expected return on investments that are not readily marketable. Other options mention factors related to yield but do not address the specific concern of liquidity. For example, the Maturity Rate Premium usually pertains to the additional yield associated with the time to maturity of a bond; Reinvestment Rate Risk concerns the uncertainty around the reinvestment of cash flows at uncertain future rates; and the Default Risk Premium relates to the potential for loss due to a borrower's failure to meet its debt obligations. None of these elements directly capture the risk of illiquidity like the Liquidity Premium does.