Illiquidity Costs Research Articles

Portfolio Choice with Illiquid Assets

We present a model of optimal allocation over liquid and illiquid assets, where illiquidity is the restriction that an asset cannot be traded for intervals of uncertain duration. Illiquidity leads to increased and state-dependent risk aversion, and reduces the allocation to both liquid and illiquid risky assets. Uncertainty about the length of the illiquidity interval, as opposed to a deterministic non-trading interval, is a primary determinant of the cost of illiquidity. We allow market liquidity to vary from `normal' periods, when all assets are fully liquid, to 'illiquidity crises,' when some assets can only be traded infrequently. The possibility of a liquidity crisis leads to limited arbitrage in normal times. Investors are willing to forego 2% of their wealth to hedge against illiquidity crises occurring once every ten years.

The Cost of Illiquidity for Private Equity Investments

We derive a theoretical upper bound for the cost of illiquidity to a private equity investor using perpetual exchange options. The model’s framework is built upon existing option‐based models for quantifying restricted stock discounts. We use the model to estimate upper bounds on the historical illiquidity discounts for private company investments in different industry sectors.

Locked Up by a Lockup: Valuing Liquidity as a Real Option

Hedge funds often impose lockups and notice periods to limit the ability of investors to withdraw capital. We model the investor's decision to withdraw capital as a real option and treat lockups and notice periods as exercise restrictions. Our methodology incorporates time-varying probabilities of hedge fund failure and optimal early exercise. We estimate a two-year lockup with a three-month notice period costs investors 1.5% of their initial investment. The magnitude is sensitive to a fund's age, expected return, and the liquidation cost upon failure. The cost of illiquidity can exceed 10% if the hedge fund manager suspends withdrawals.

Analysing liquidity and absorption limits of electronic markets with volume durations

This paper focuses on the liquidity of electronic stock markets applying a sequential estimation approach of models for volume duration with increasing threshold values. A modified ACD model with a Box–Tukey transformation and a flexible generalized beta distribution is proposed to capture the changing cluster structure of duration processes. The estimation results with German XETRA data reveal the market's absorption limit for high volumes of shares, expanding the time costs of illiquidity when trading these quantities.

The Complete Picture of Credit Default Swap Spreads - A Quantile Regression Approach

We study the determinants of Credit Default Swap (CDS) spreads through quantile regressions. The results indicate that CDS spreads are strongly determined not only by traditional theoretical variables, such as the implied volatility and put skew, but also by illiquidity costs. However, contrary to stocks or bonds, we show that CDS transaction costs should be measured by absolute, rather than relative, bid-ask spreads. The quantile regressions reveal significant heterogeneity in the response of low-risk versus high-risk firms, with both the coefficients on the explanatory variables and the goodness-of-fit of the model increasing with the quantile of CDS premiums. The results obtained with a classical conditional mean regression, as used in most previous empirical studies, are very far from describing the centre of the CDS distribution, being more representative of the higher quantiles. These results are also helpful to understand the credit spread puzzle.

Private Equity Funds: Valuation, Systematic Risk and Illiquidity

We derive a novel model of the cash flow dynamics and equilibrium values of private equity funds. Based on intertemporal capital asset pricing results for an investor with logarithmic utility, the model explains a life cycle of systematic fund risk and fund value. The closed form solution allows us to predict the typical dynamics of fund values, time varying systematic risk as well as expected returns, and considers market illiquidity. Our model calibration illustrates that a European sample of funds has an average risk adjusted excess value of 14 percent relative to committed capital, which amounts to average illiquidity costs of 1.4 percent annually. We show how equilibrium expected fund returns, systematic risk, and illiquidity discounts decrease over fund lifetime. As compared to venture capital funds, buyout funds on average exhibit lower systematic risk, faster payback, lower life cycle maximum values, but higher initial excess values.

Locked Up by a Lockup: Valuing Liquidity as a Real Option

Hedge funds often impose lockups and notice periods to limit the ability of investors to withdraw capital. We model the investor's decision to withdraw capital as a real option and treat lockups and notice periods as exercise restrictions. Our methodology incorporates time-varying probabilities of hedge fund failure and optimal early exercise. We estimate a two-year lockup with a three-month notice period costs approximately 1% of the initial investment for an investor with CRRA utility and risk aversion of three. The cost of illiquidity can easily exceed 10% if the hedge fund manager can arbitrarily suspend withdrawals.

Stock and Bond Liquidity and its Effect on Prices and Financial Policies

An asset is liquid if it can be traded at the prevailing market price quickly and at low cost. We show that in addition to risk, liquidity affects asset prices and returns. Theories of asset pricing suggest that the expected return of an asset is increasing in its risk, because risk-averse investors require compensation for bearing more risk. Because investors are also averse to the costs of illiquidity and want to be compensated for bearing them, asset returns are increasing in illiquidity. Thus, asset prices should depend on two asset characteristics: risk and liquidity. This paper surveys research on the effects of liquidity on asset prices and returns, showing that liquidity is an important factor in capital asset pricing.

Marketability and Value: Measuring the Illiquidity Discount

Should investors be willing to pay higher prices for more liquid assets than for otherwise similar assets that are less liquid? If the answer is yes, how much should the premium be for liquid assets? Conversely, how do we estimate the discount for illiquid assets? In this paper, we argue that it is a mistake to think of some assets as illiquid and others as liquid and that liquidity is a continuum, where some assets are more liquid than others. We then examine why liquid assets may be priced more highly than otherwise similar illiquid assets and why some investors value liquidity more than others. We follow up be presenting the empirical evidence that has accumulated over time and across different assets - financial and real - on the cost of illiquidity. Finally, we consider how we can use the theory and evidence on illiquidity to estimate the effect of illiquidity on the value of an asset or business.

Investment with restricted stock and the value of information

In most public companies in China, there are two thirds of shares that cannot be traded freely in the secondary market. These illiquid shares, however, may be allowed to circulate unexpectedly one day. This paper delves into the investor's financial decision-making with restricted stock in a continuous-time framework. Accordingly, this paper assumes that removal of trade restriction arrives as a Poisson process. In the spirit of [Rev. Econom. Statist. 51 (1969) 247; J. Econom. Theory 3 (1971) 373], an analytical solution to the investor's optimal portfolio problem is derived and the price (or cost) of illiquidity can be calculated using numerical method. Furthermore, the value of information is discussed in this framework. Numerical simulation shows that illiquidity has an important influence on the investor's optimal strategy. This model may provide a theoretical framework to assess the cost of state-owned equities (SOEs).

Investment with Restricted Stock and the Value of Information

In most public companies in China, there are two thirds of shares that can't be traded freely in the secondary market. These illiquid shares, however, may be allowed to circulate unexpectedly one day. This paper delves into the investor's financial decision-making with restricted stock in a continuous-time framework. Accordingly, this paper assumes that removal of trade restriction arrives as a Poisson process. In the spirit of Merton(1969,1971), an analytical solution to the investor's optimal portfolio problem is derived and the price (or cost) of illiquidity can be calculated using numerical methods. Furthermore, the value of information is discussed in this framework. Numerical simulation shows that illiquidity has an important influence on the investor's optimal strategy. This model may provide a theoretical framework to assess the cost of state-owned equities (SOEs).

Go Public or Stay Private: A Theory of Entrepreneurial Choice

In this paper we analyze an entrepreneur/manager's choice between private and public ownership in a setting in which management needs some elbow room or autonomy to optimally manage the firm. In public capital markets, the corporate governance regime in place exposes the firm to exogenous controls, so that management may lack the autonomy it desires. By contrast, private ownership can provide management the desired autonomy due to the possibility of precisely-calibrated private contracting. The disadvantage of private ownership (relative to public ownership) is that it imposes a cost of illiquidity on those who provide financing. We explore this tradeoff between managerial autonomy and the cost of capital in a simple setting and draw a number of new testable implications.

Testing the Informational Efficiency of OTC Options on Emerging Market Currencies

This paper analyzes the informational efficiency of OTC currency options on the Czech koruna and the Polish zloty correcting for the volatility risk premium and errors-in-variable problems, using state-of-the-art techniques (Chernov 2001). It finds that these markets are more efficient than mature markets possibly because of higher relative participation of informed dedicated investors, which offset the effects of relative illiquidity and higher transaction costs in these countries. Moreover, implied volatilities generally anticipate the direction of volatility correctly, with a bias to overpredicting volatility increases reflecting one-sided markets.

Private Equity Risk and Reward

In addition to its high historical returns, private equity is widely viewed as an attractive asset class due to its relatively low return volatility and low return correlation with other asset classes. However, the illiquid nature of private equity presents a key challenge for investors in assessing the precise underlying risk and reward potential embedded in the asset class. Namely, sluggish adjustment of net asset values by general partners of private equity funds implies that the return volatility and return correlations with other asset classes are likely understated. In this report, we outline a methodology for mitigating this sluggish adjustment problem by using long-horizon return data to allow for a more accurate assessment of private equity9s diversification benefits and underlying risk/return characteristics. While the use of long-horizon return data indicates an increase in the correlation between private and public equity returns, implying fewer diversification benefits than indicated by quarterly data, the Sharpe ratios (i.e., proxies for risk-adjusted returns) for private equity remain substantially higher than corresponding Sharpe ratios for public equity. Additionally, for investors with long investment horizons, where annual return variability and illiquidity costs are largely immaterial, the absolute long-run historical return differentials between private and public equity are very large and, therefore, imply very large differences in end-of-period wealth.

Optimal Portfolio Choice and the Valuation of Illiquid Securities

Traditional models of portfolio choice assume that investors can continuously trade unlimited amounts of securities. In reality, investors face liquidity constraints. I analyze a model where investors are restricted to trading strategies that are of bounded variation. An investor facing this type of illiquidity behaves very differently from an unconstrained investor. A liquidity-constrained investor endogenously acts as if facing borrowing and short-selling constraints, and one may take riskier positions than in liquid markets. I solve for the shadow cost of illiquidity and show that large price discounts can be sustained in a rational model. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Liquidity Risk, Liquidity Creation, and Financial Fragility: A Theory of Banking

Loans are illiquid when a lender needs relationship‐specific skills to collect them. Consequently, if the relationship lender needs funds before the loan matures, she may demand to liquidate early, or require a return premium, when she lends directly. Borrowers also risk losing funding. The costs of illiquidity are avoided if the relationship lender is a bank with a fragile capital structure, subject to runs. Fragility commits banks to creating liquidity, enabling depositors to withdraw when needed, while buffering borrowers from depositors' liquidity needs. Stabilization policies, such as capital requirements, narrow banking, and suspension of convertibility, may reduce liquidity creation.

The liquidity premium in equity pricing under a continuous auction system

The paper shows that the cost of illiquidity is not (positively) priced over all months in the Spanish continuous auction system, where liquidity is provided in the absence of market makers. Two distinct approaches are employed. Both the two-step traditional cross-sectional method and the pooled cross-section time series analysis tend to indicate that the liquidity premium is negative during months other than January. Moreover, the liquidity premium in January is positive (although not significant) and at the 10% level it seems to be significantly higher than the liquidity premium over the rest of the year. Therefore, given the previous results for the US market, we conclude that, independently of the market trading mechanism with the exception of NASDAQ, the behaviour of the relationship between the bid-ask spread and stock returns is rather similar.

Market microstructure and asset pricing: On the compensation for illiquidity in stock returns

Models of price formation in securities markets suggest that privately informed investors create significant illiquidity costs for uninformed investors, implying that the required rates of return should be higher for securities that are relatively illiquid. We investigate the empirical relation between monthly stock returns and measures of illiquity obtained from intraday data. We find a significant relation between required rates of return and these measures after adjusting for the Fama and French risk factors, and also after accounting for the effects of the stock price level.

Liquidity and the 1987 stock market crash

T he Crash of October 1987 was a puzzling event puzzling not only for what happened on October 19, but also for what subsequently did not happen. In spite of the magnitude and momentum of the crash, its effect was limited primarily to the financial markets, while the economy as a whole did not change its course. And, although the ”bad news” that was supposed to be predicted by the crash has apparently not materialized, the market suffered a lasting decline after October of 1987. This article advances a liquidity theory of the crash, proposing that the price decline in October 1987 reflects, at least in part, a revision of investors’ expectations about the liquidity of the equity markets. Amihud and Mendelson [1986a, 1986b, 19891 have shown that the market price of stocks is positively associated with their liquidity (after controlling for risk). Given this relationship, when the liquidity of assets turns out to be less than had been expected, their price should decline. We suggest that the main news that caused the prolonged decline in stock prices was the crash itself that is, the realization that financial markets are not as liquid as previously assumed. Investors recognized that stock prices should reflect a larger discount for the costs of illiquidity, which turned out to be much higher than had been expected before the crash. Partial recovery following the crash reflects an upward reevaluation of the liquidity of the markets -that is, investors recognized that while the markets are not as liquid as had been assumed prior to the crash, they are also not as illiquid as when there was the possibility of closing the markets altogether. These illiquidity problems, reflected in wider spreads between the quoted bid and ask prices, have persisted long after the crash, and market impact estimates have stayed significantly larger than they had been prior to the crash.’ Thus, the crash and subsequent events have produced new information about the markets themselves rather than fundamental news about the economy. Part of the liquidity-related price decline on October 19, 1987, was temporary. Unexpected sale pressure, even absent any negative information, can generate a temporary negative price impact, as we sometimes observe in block sales. But much of the effect was permanent. Investors realized that they may well have to pay a larger discount when they wish to sell stocks in a hurry. These illiquidity costs result in a stream of future cash outflows that translate into a loss of value.2 In general, illiquidity reflects the difficulty of converting cash into assets and assets into cash, or the costs of trading an asset in the market. Some of the costs of illiquidity are explicit and easy to measure, while others are more subtle. These costs include the bid-ask spread, market-impact costs, delay and search costs, and brokerage commissions and fees. These components of illiquidity cost are highly correlated: Stocks that have high bid-ask spreads also have high transaction fees and high search and market-impact costs, and are thinly traded (McInish and Wood [1989]). When the bid-ask spread widens, it signals that immediacy of execution is more costly,

Insider Holdings and Perceptions of Information Asymmetry: A Note

RESEARCHERS HAVE FOUND THAT trades by corporate insiders yield excess profits (for example, Finnerty [9] and Jaffe [11]). In an efficient capital market, we should expect other market participants to consider this in their investment/ trading decisions. Demsetz [7] notes that, to protect themselves, ordinary (uninformed) investors may adopt a buy-and-hold strategy but incur the cost of illiquidity in doing so. Therefore, he argues, the recorded rates of return (measured before losses to insiders) should be higher for stocks more likely to present outsiders with informationally disadvantageous trades. Based on a 159firm sample, he finds that there is a significant positive correlation between the recorded market rates of return and the ratio of insider trading to total trading. In this paper, we study the market's perception of information asymmetry between insiders and outsiders through the behavior of another group of tradersthe dealers/specialists. The degree of information asymmetry is proxied here by the concentration of insider holdings. The dealer/specialist provides the trading public the service of immediacy by standing ready to buy and sell. He or she incurs, in the process, inventory holding costs and information trading costs, which are the expected losses due to transactions with informed traders. Therefore, the dealer/specialist sets the bidask spread (his or her source of revenue) according to the anticipated levels of these costs. In particular, it has been shown that the higher the information trading cost, the wider the spread should be (Jaffe and Winkler [12], Copeland and Galai [6], and Glosten and Milgrom [10]). Thus, ceteris paribus, a higher degree of information asymmetry leads to a larger bid-ask spread. The question, then, is what factors influence the dealer's assessment of information asymmetry. One convenient measure is the extent of insider holdings. Corporate insiders have access to nonpublic firm-specific information and exercise a good deal of corporate control. We use the percentage of ownership by corporate insiders as a proxy for the degree of information asymmetry faced by the dealer. A positive correlation between spreads (net of holding costs and firm-size effects) and insider holdings would imply that dealers perceive a positive relationship between insider holdings and information asymmetry. We also study how the market views institutional holdings through the effect on bid-ask spread. Compared with the typical stockholder, institutions tend to hold larger blocks of a firm's stock; thus, their information acquisition costs are spread over a larger investment, creating an incentive to acquire information.