Alternative Viewpoints: “Liquidity Alpha”
Nov 27th, 2007 | Filed under: CAIA Alternative Viewpoints Columns, CAPM / Alpha Theory, Guest PostsALTERNATIVE VIEWPOINTS …powered by CAIA
As part of our on-going series of features written by holders of the Chartered Alternative Investment Analyst (CAIA) designation, we are pleased to bring you this piece by Ranjan Bhaduri, Ph.D., CFA, CAIA. Dr. Bhaduri is Vice President in the Graystone Research group at Morgan Stanley. Prior to this, he was with a multi-billion dollar capital management firm where he was involved in all aspects of its fund of hedge funds and structured finance business. He has also held advisory roles at the East-West Center, a leading think tank on the Asia-Pacific region and has taught finance and mathematics at several universities. He is the author of several articles on advanced risk management techniques and hedge fund issues and is a member of the American Mathematical Society, the Mathematical Association of America and the Global Association of Risk Professionals. Dr. Bhaduri also serves on the Advisory Council of the World Trade University.
Dr. Bhaduri has just returned from a speaking tour that took him from Chicago to London and Beijing where he addressed audiences on the role of liquidity in hedge fund returns.
“Liquidity Alpha”
By: Ranjan Bhaduri, special to AllAboutAlpha.com
The word liquidity gets bandied about quite a lot, but it is surprising how many portfolio managers take a naïve approach to liquidity. It is well known that one should be compensated for investing in less liquid instruments (liquidity premium), but how much? What is the value of liquidity?
It is dangerous in merely trust one’s intuition on the value of liquidity. Consider the following one-person game:
The “Balls in the Hat Game”
The game consists of a hat that contains 6 black balls and 4 white balls. The player picks balls from the hat and gains $1 for each white ball, and loses $1 for each black ball. The selection is done without replacement. At the end of each pick, the player may choose to stop or continue. The player has the right to refuse to play (i.e. not pick any balls at all). Given these rules, and a hat containing 6 black balls and 4 white balls, would you play? (Why?)
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