Financial institutions face the possibility of liquidity shocks, that is, sudden and unexpected cash requirements. To raise the cash, firms may be forced to sell assets, not at fair value but subject to a haircut reflecting the urgency of the sale.
Illiquidity premiums embedded in asset yields may compensate investors for the contingent future haircuts. However, it cannot exactly compensate all investors, because different institutions face different frequencies and severities of liquidity shocks. Those exposed to large or frequent shocks should avoid illiquid assets altogether. Other investors may find themselves over-compensated relative to the haircuts they face, especially if they exercise their option to sacrifice assets in order of liquidity.
We describe a new multi-investor model to explain illiquidity premiums and sacrifice options, illustrated with simple numerical examples. The model has implications for investment strategy and the pricing of insurance and pensions products.