The price of liquidity in the reinsurance of fund returns

Abstract

We consider a new type of contract for insuring the returns of hedge funds and aim to extend downside protection to an investment portfolio beyond the first tranche of losses insured by first-loss fee structures, which have become increasingly popular in the market. By considering a second tranche, we suggest an up-front premium to a reinsurance party, in exchange for which the investor gains full protection against all losses, not just those occurring in the first tranche. We identify a fund’s underlying liquidity as a key parameter in deriving the price for the additional reinsurance and provide a method for computing the premium using two approaches: an analytic closed-form solution based on the Black–Scholes framework, and a numerical simulation using a Markov-switching model. In addition, a simplified backtesting method is implemented to evaluate the practical application and performance of the concept for both mathematical models.