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1.

0 Liquidity
Liquidity describes the degree to which an asset or security can be quickly bought or sold in
the market without affecting the assets price. An asset that can be converted into cash
immediately are said to be have high liquidity and asset that cannot be converted into cash
immediately are considered low liquidity. The more liquid an asset is, the more desirable it is
(holding everything else constant) (Mishkin, 2009). Generally, liquidity is defined as the
ability of a firm to meet its debt obligations without incurring unacceptably large losses.
For example, if a person wanted to buy a refrigerator worth RM1000 but has no
cash, he probably have a painting collection worth RM1000, he unlikely hard to find
someone that willing to trade the painting collection for a refrigerator. Instead he needs to
sell the collection and use the cash to purchase the refrigerator he might happen to take a
long time to sell the collection and if he need sell, he might sell the collection at discount
which the painting collection can be said as the illiquid asset because it cannot converted
into cash as immediate as the assets owner wanted and cannot sustained its value.
Investors are care about liquidity; they are willing to accept a lower interest rate on
more liquid investment than on less liquid illiquid investment, all other things being equal.
Hence a less liquid asset must pay a higher yield to compensate savers for their sacrifice of
liquidity. (Hubbard, 2005)

1.1 Liquidity Premium


Liquidity premium is a premium that investors will demand when any given security
cannot be easily converted into cash, and converted at the fair market value. When the
liquidity premium is high, then the asset is said to be illiquid, which will cause prices to fall
and interest rates to rise.
We can use US Treasury securities to compare liquidity among different financial
instruments. Markets for Treasury securities are extremely liquid, whereas matching buyers
and sellers of corporate bonds is more difficult. Therefore corporate bond markets are much
less liquid than government bond market and so investors require an additional premium in
their yields. (Hubbard, 2005)

1.2 Changes in liquidity and liquidity premium (Hubbard, 2005)


The theory of portfolio allocation tells us that for any yield, investor prefer to hold
more liquid instruments such as government bonds than illiquid ones. Therefore, if the
market for corporate bonds becomes less liquid, the spread between yields on less liquid
and more liquid instruments increases.
Lenders value liquidity. Therefore an instrument traded in a less liquid market will
have a lower price and greater required return than an instrument traded in a more liquid
market.
a. A decrease in liquidity causes lenders to decreases their demand curve for that
asset, shifting the demand curve from Bdilliq0 to Bdliliq1. This shifted lowers the price
and raises the yield in the illiquid market.
b. Lenders reallocate their funds from the less liquid market to the more liquid
market, shifting the demand curve from Bdliq0 to Bdliq1. As a result, the price rises
and the interest rate falls in the more liquid market, while the price falls, the
interest rate rises in the less liquid market.
c. The liquidity premium embodied in the change in the spread in bond prices the
difference in the yield on the less liquid instruments equals iilliq1 iilliq0. Lenders
are less willing to hold the illiquid instrument and require a higher return;
borrowers using that instrument to raise funds will have higher costs of funds. An
increase in the liquidity of an asset reduces its required of return; a decrease in
liquidity raises the required of return.

Figure 1
The difference between Pliq1 Pilliq1 is the premium that the investor received as they willing to
take position on the less liquid market.
2.0 Taxation
2

Taxation refers to the act of a taxing authority actually levying tax. The tax levied by a
government on a product, income or activity were to finance government expenditure. One
of the most important uses of taxes is to finance public goods and services such as street
lighting and cleaning. Tax can be indirect tax and direct tax.

2.1 Tax Treatment


In determining whether interest is taxed, savers must compare differing tax rates on
the returns from their investment. Investor would prefer to invest in tax-exempt bonds than
taxable bonds. This is because a taxable income in the yield would affect their income from
the investment. For example, interest received on municipal bonds is obligations of state
and local government, is exempt from federal, state and local income taxes, rather than
treasury bonds which the municipal bond will have higher after-tax yield.

Figure 2
If nothing else changes, a decrease in a bonds tax liability raises it prices and decreases its
yield.
a. If municipal bonds become tax exempt, lenders decrease their holdings of
taxable US government bonds, and the demand curve shifts to the left, from
Bdtax0 to Bdtax1 in (b), reducing the price of taxable bonds.
b. Lenders increase their demand for tax-exempt bonds, so that the demand curve
shifts from Bdtax-ex0 to Bdtax-ex1 in (a), raising the price of tax-exempt bonds.
c. The difference in the bond prices is matched by a difference in the required
returns. The gap between itax1 and itax-ex1 is the tax component of the difference in
yields.
REFERENCES

Hubbard, R. G. (2005). Money, the Financial System, and the Economy, 5th Edition, United
States: Pearson Addison-Wesley.
Income Tax Treatment, Retrieved from:
http://www.investopedia.com/exam-guide/cfp/income-respect-decedent/cfp3.asp
Mishkin, Frederic S. (2009). The Economics of Money, Banking & Financial Market, 10th
Edition, New York: Pearson Addison-Wesley
What is Liquidity Risk? , Retrieved from:
http://www.frbsf.org/economic-research/publications/economicletter/2008/october/liquidity-risk/