Capital quality and the illiquidity premium

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Article by Malcolm Kemp – 27 May 2010

Copyright (c) Malcolm Kemp 2010

The issue of whether to include an illliquidity premium in the valuation of illiquid long-term liabilities has shot to prominence recently. In this article I have not tried to explore the strength of the arguments for or against an illiquidity premium (or about how any such premium should be calculated). Interested readers are directed towards Kemp (2009) and CEIOPS (2010). Instead I have highlighted an element of the debate that I think has not (yet) gained the prominence that it deserves. This is the link between the valuation impact of any illiquidity premium and the ‘quality’ of capital that the entity concerned has to back its liabilities. Arguably, the ‘asset’ (liability offset) created by including an illiquidity premium is less resilient than some other asset types in a ‘gone concern’ situation. It may therefore be appropriate to limit the proportion of the entity’s overall capital base that such an asset can form, as often applies to other assets exhibiting similarly limited resilience in such situations.

Contents

1.       The current debate on the illiquidity premium

2.       Capital quality

3.       The link between the illiquidity premium and capital quality

References

Malcolm Kemp is Managing Director of Nematrian Limited, see http://www.nematrian.com/Introduction.aspx. The views expressed in this article are personal to the author.

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