Liquidity and tax treatment

8/15/2019 Liquidity and tax treatment

1/4

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 asset’s price. An asset that can be converted into cash

immediately are said to be have high liquidity and asset that cannot be converted into cashimmediately are considered low liquidity. The more liquid an asset is, the more desirable it is

(holding everything else constant (!ishkin, "##$. %enerally, liquidity is defined as the

ability of a firm to meet its debt obligations without incurring unacceptably large losses.

&or e'ample, if a person wanted to buy a refrigerator worth !)### but has no

cash, he probably have a painting collection worth !)###, he unlikely hard to find

someone that willing to trade the painting collection for a refrigerator. *nstead 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 asset’s owner wanted and cannot sustained its value.

*nvestors 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.

-ence a less liquid asset must pay a higher yield to compensate savers for their sacrifice of

liquidity. (-ubbard, "##

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. /hen the

liquidity premium is high, then the asset is said to be illiquid, which will cause prices to fall

and interest rates to rise.

/e can use 01 Treasury securities to compare liquidity among different financial

instruments. !arkets for Treasury securities are e'tremely 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. (-ubbard, "##

1


2/4

1.2 Changes in liquidity and liquidity premium (-ubbard, "##

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 liquidand 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 Bd illiq0 to Bd liliq1. 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 Bd liq0 to Bd liq1. 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 i illiq1 – i illiq0 . 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 it’s required of return+ a decrease in

liquidity raises the required of return.

The difference between P liq1 – P illiq1 is the premium that the investor received as they willing to

take position on the less liquid market.

2.0 Taxation

2

&igure )


3/4

Ta'ation refers to the act of a ta'ing authority actually levying ta'. The ta' levied by a

government on a product, income or activity were to finance government e'penditure. 2ne

of the most important uses of ta'es is to finance public goods and services such as street

lighting and cleaning. Ta' can be indirect ta' and direct ta'.

2.1 Tax Treatment

*n determining whether interest is ta'ed, savers must compare differing ta' rates on

the returns from their investment. *nvestor would prefer to invest in ta'3e'empt bonds than

ta'able bonds. This is because a ta'able income in the yield would affect their income from

the investment. &or e'ample, interest received on municipal bonds is obligations of state

and local government, is e'empt from federal, state and local income ta'es, rather than

treasury bonds which the municipal bond will have higher after3ta' yield.

*f nothing else changes, a decrease in a bond’s ta' liability raises it prices and decreases its

yield.

a. *f municipal bonds become ta' e'empt, lenders decrease their holdings of

ta'able 0’1 government bonds, and the demand curve shifts to the left, from

Bd tax0 to Bd tax1 in (b, reducing the price of ta'able bonds.

b. Lenders increase their demand for ta'3e'empt bonds, so that the demand curve

shifts from Bd tax-ex0 to Bd tax-ex1 in (a, raising the price of ta'3e'empt bonds.

c. The difference in the bond prices is matched by a difference in the required

returns. The gap between i tax1 and i tax-ex1 is the ta' component of the difference in

yields.

REFERENCE

3

&igure "


4/4

-ubbard, . %. ("##. Money, the Financial System, and the Economy , th 4dition, 0nited

1tates5 6earson Addison3/esley.

*ncome Ta' Treatment, etrieved from5

http577www.investopedia.com7e'am3guide7cfp7income3respect3decedent7cfp8.asp

!ishkin, &rederic 1. ("##$. The 4conomics of !oney, 9anking : &inancial !arket, )# th

4dition, ;ew

Documents

Liquidity and tax treatment