Say that your choices were a money market account offering a yield of 1.5% with access to your money at any time without penalty, or a one-year certificate of deposit offering a yield of 2.0% but with a six-month interest penalty if you cashed in before the year was up. What is the liquidity cost of buying the CD if you cashed it in on the 364th day?
Your immediate answer would probably be 1% because if the CD yield is 2.0% and the penalty is six-months interest, or half a year’s interest, to calculate it you would simply multiply 2.0% by one half and come up with 1.0%. But that does not accurately reflect the liquidity cost.
The CD yield is 2.0%. After subtracting the 1% penalty the net after-penalty yield of the CD is 1.0%. The money market account had a net yield of 1.5%. If we surrender the CD early we do not make 1% less than the money market account. We make 0.5% less. The liquidity cost of cashing in the CD is not 1% - the penalty, it is 0.5% - the difference between what we would have earned with the other choice.
Behind the concept of Liquidity Cost is the realization that financial decisions are not made in a vacuum, but are always a choice between alternatives and you need to compare the net after-penalty yields to determine the true liquidity cost.
What if our choices were a five-year certificate of deposit with a six-month interest penalty or the money market account? The traditional answer would be the CD must have a greater liquidity cost because the penalty goes on for 5 years. But what if the CD yielded 4% and the money market yielded 1.5% and we cashed in the CD after one year? The surrender penalty for the CD would be six months interest, or 2%, leaving us with a net after-penalty yield of 2.0%. The money market yield is 1.5%, a half percent less than the net CD yield. In this situation it is not the CD that has a liquidity cost but the money market! Owning the money market has cost us 0.5% after one year.
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