CFA Level I · CFA Level I Exam · The Time Value of Money in Finance
Two otherwise identical bonds have the same maturity and credit quality, but Bond X trades rarely while Bond Y trades actively. All else equal, Bond X's required rate of return is most likely:
Bond X most likely has a higher required return because investors demand a liquidity premium for a security that is hard to sell quickly at a fair price. Maturity and credit quality are the same, so those premiums do not differ.
- Alower, because of a lower default premium
- Bequal, since maturity and credit quality match
- Chigher, because of a liquidity premiumCorrect
Explanation
Investors demand a liquidity premium for securities that are costly or slow to sell. With maturity and credit quality identical, the default and maturity premiums are the same, so the difference in required return is driven by liquidity, making Bond X's higher.
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