Does This Make Any Sense?

From The Australian : There's a price to pay for illiquidity

Which brings us to Peter Swan's paper on the equity premium. He describes his explanation of the equity premium as very simple.

"While financial economists are used to thinking of equity markets as being highly liquid, they are in fact highly illiquid relative to government securities such as bonds and Treasury bills," he says. "In the US over the 21-year period, 1980-2000 the average turnover rate for US government bonds and Treasury bills was 13.9 times per annum compared with 0.575 times per annum for equity on the New York Stock Exchange, a relative rate of 24.58 times ... My basic idea is that the equity premium is no more than compensation to equity holders for this greater illiquidity."

Swan has presented his paper by invitation to leading finance and business schools in the US and it appears to be stirring up interest.

This seems absurd to me. Collectible paintings of recognized masters are illiquid. If US government bonds turned over 100 times as often as they do would their total return really be reduced by a measurable amount, let alone a significant one?

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Makes no sense to me either.

Makes no sense to me either. Liquidity is the time & cost to sell, not how often you choose to do so. He is acting as though liquidity is a synonym for velocity. But the cost of transferring something (liquidity) is not the only factor in determining how often it is transferred (velocity). There is also how long you want to use/own it for.

Patri has it right.

Patri has it right. Liquidity is the ability to sell, not the actual amount sold.

The correct gauge of liquidity is spread -- the difference between the ask and the bid. For most large-cap exchange-traded (i.e., liquid) equities, the spread is just one cent or a few cents, not significantly different from Treasury securities. For small-cap or thinly traded (i.e., illiquid) stocks, the spread is much higher.

Stocks are more volatile than bonds. Anyone who tries to devise an alternative explanation for the equity risk premium is overthinking.

Is the reason he is stirring

Is the reason he is stirring up interest so that people can shred him on their own campus?

continuing where Kip left off...

If you owned both the equity and debt of Ford and Ford went bankrupt what would happen to the value of each? The bondholders have a claim on the assets and could liquidate them in order to recoup some of their investment. Stock holders may get something if there is anything left over. The bonds would trade at around 30 cents on the dollar and the stock could be used as wallpaper.

Now, if Ford designs a hover craft for $500 that runs on self generated energy and can hit mach 1, the bondholders will only get their coupon, while the equity holders will reap a windfall.

Put those two sceanrios together and that is the equity premium.

Patinator, All true, but the


All true, but the normal subject of the equity premium is between a stock index and government bonds.

Regards, Don

To elaborate on what Don's

To elaborate on what Don's saying, the high volatility of returns from individual stocks can't be a factor in the equity premium. Because investors can eliminate this risk through diversification, only the volatility of the market as a whole could (in theory) explain the equity premium.

Anyway, the puzzle is not that there is an equity premium, but that the premium is so large that it implies an improbably high degree of risk-aversion. The paper is here, if anyone wants to read it.