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The Expected Illiquidity Premium: Evidence from Equity Index-Linked Bonds

29 Pages Posted: 31 Dec 2000  

Elroy Dimson

University of Cambridge - Judge Business School; London Business School

Bernd Hanke

London Business School - Institute of Finance and Accounting

Multiple version iconThere are 2 versions of this paper

Date Written: December 2002

Abstract

We examine a set of equity index-linked bonds that provide the same payoff as an investment in an equity index but are relatively illiquid. We demonstrate that these securities sell at a discount relative to their underlying value and hence have higher expected returns. We show that this apparent mispricing can be attributed to the illiquidity of the bonds. Trading costs for equity-linked bonds, as measured by bid-ask spreads, are free of any asymmetric information or inventory holding cost component; hence the only illiquidity component left is clearing costs. This study shows that even in the absence of asymmetric information and inventory holding costs, illiquidity depresses asset prices and therefore increases expected security returns. We have time series for more than a decade of a clean measure of the expected return premium due to illiquidity. This enables us to link time variation in the illiquidity premium to security-specific attributes related to their marketability. We show that liquidity risk has a systematic component, and relate this market-wide factor to a number of macroeconomic variables that have previously been shown to be related to illiquidity.

Keywords: Illiquidity, equity returns

JEL Classification: G12

Suggested Citation

Dimson, Elroy and Hanke, Bernd, The Expected Illiquidity Premium: Evidence from Equity Index-Linked Bonds (December 2002). London Business School Accounting Subject Area No. 014. Available at SSRN: https://ssrn.com/abstract=248617 or http://dx.doi.org/10.2139/ssrn.248617

Elroy Dimson

University of Cambridge - Judge Business School ( email )

Trumpington Street
Cambridge, CB2 1AG
United Kingdom
+44 20 7000 8212 (Phone)
+44 700 607 7390 (Fax)

London Business School ( email )

Sussex Place
Regent's Park
London, NW1 4SA
United Kingdom
44 20 7000 7000 (Phone)
44 700 607 7390 (Fax)

Bernt Hanke (Contact Author)

London Business School - Institute of Finance and Accounting ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom

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