Quantifying the Liquidity Premium in Emerging Market Trading

Developed markets are currently beset with credit risk even though there is not much of a liquidity risk in these markets. However, it is the other way round in developing markets. They are undeveloped in part due to lack of sophisticated hedging tools, and investors typically have to cover any short positions before the close of trade. Developing economies are still striving for more efficient and competitive domestic financial markets as there exist structural constraints that are not easy to overcome. As part of this process, there is an increased emphasis on creating a liquid financial market that would help market participants price current and future assets accurately and help mitigate risks. In this article, we provide a framework for estimating the liquidity premium in developing markets. The framework is generic and is applicable for all emerging markets.