2.5 Liquidity Risk Premium

A natural question then is how much is this liquidity risk premium. We’ll start, though, with how we determine the market risk premium. We usually do this by measuring the performance of a market, for example the equity market, over a long period of time and then subtract out the yield of a long-maturity Treasury bond. The S&P 500 index, for example, has returned about 9% per year over the last hundred years. The current 30-year Treasury bond yield is about 4%. This leads to a market risk premium of 9%-4% = 5% per annum.¹² This is the market risk premium for taking an amount of market risk equal to a market beta of 1. If a U.S. equity investor holds a portfolio with a market risk equal to a market beta of 2, he would expect to earn a market premium of 10% on that portfolio. Holding a portfolio with a market beta of 0.5 would lead to an expected market premium of 2.5% on that portfolio.