What does the liquidity premium compensate investors for?

The liquidity premium compensates investors for taking on the additional risk associated with holding less liquid securities. Less liquid securities are those that cannot be easily bought or sold in the market without causing a significant impact on their price. This lack of liquidity can lead to greater uncertainty regarding the timing and pricing of exits, making these investments less attractive compared to more liquid options.

Investors expect to receive a higher return—known as a liquidity premium—on these securities as compensation for the risk of being unable to quickly convert their investment into cash. This rationale is grounded in the principle that investors require additional rewards for accepting increased risk, which in this case relates directly to liquidity concerns.

The other answer choices address various aspects of investment risk, but they do not specifically relate to the concept of liquidity premium. While trading in highly volatile markets and investing in high-risk financial instruments may present their own sets of risks, they do not encapsulate the essence of the liquidity premium, which is distinctly related to the characteristics of liquidity in investments.