In December, guest contributor Ranjan Bhaduri, CAIA examined the cost of liquidity by using a simple exercise that he called the “balls in the hat game”.  Bhaduri argued that illiquidity – a source of excess return – is often confused with “true alpha”.  Today Konstantin Danilov, CAIA, of Bank of America proposes a new type of security that could be used to hedge against the possibility of an illiquidity crisis. Danilov conducts buy-side manager research at BofA.  Prior to this, he was a trader at Cantella & Co.  He is also a member of the Program Subcommittee for Alternative Investments and Hedge Funds of the Boston Security Analysts Society.

His guest contribution below is the latest in a monthly series featuring members of the Chartered Alternative Investment Analyst (CAIA) Association.

“Liquidity Insurance”

Special to AllAboutAlpha.com by: Konstantin Danilov, CAIA, Bank of America

“Our current system of levered finance and its related structures may be critically flawed. Nothing within it allows for the hedging of liquidity risk, and that is the problem at the moment.   -William H. Gross, Chief Investment Officer of Pimco, New York Times Aug. 10th, 2007

Liquidity is a topic that is brought up often in the wake of a financial crisis. The crash of 1987, LTCM, Amaranth, and the current sub-prime crisis are all examples of the devastating impact of illiquidity.  Unfortunately, it is a factor that eludes the most risk management tools and risk/return models in modern financial theory.  For example, Value-at-Risk (VAR) and “portfolio insurance” largely ignored illiquidity (or assumed it away) and we were left with the consequences.

However, illiquidity in a less extreme form affects market participants on a daily basis in the form of everyday transaction costs. Returns on a stock position that exist on paper can quickly disappear when a manager attempts to sell it to capture a profit, especially if the stock is thinly traded.  I’d like to focus on these transaction costs in this posting.

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