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“Liquidity Insurance”

Mar 3rd, 2008 | Filed under: CAIA Alternative Viewpoints Columns, CAPM / Alpha Theory, Guest Posts

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.

More…


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6 comments
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  1. […] “Liquidity Insurance” […]

  2. “Likewise, a ”liquidity insurance” contract could be issued by the institutions that have knowledge of the true liquidity of a certain stock.”

    You may be more informed than I am, but it’s my impression that the banks don’t have a very good understanding of liquidity — and therefore are not equipped to sell this contract.

  3. Hi Konstantin,

    Thanks for the excellent post! This idea of a liquidity derivative similar to a CDS contract is something that can be explored further in the Winter 2007 issue of the Journal of Alternative Investments. Gunter Meissner, James You, and I wrote a paper that was published in that issue entitled “Hedging Liquidity Risk: Potential Solutions for Hedge Funds”. Without rapping too much, I think that this is an idea that can add tremendous value in portfolio management for Pensions, Endowments, and Fund of Hedge Funds. It is a simple, natural, and effective solution. Again, thanks for your post - it is indeed positive that people like you are thinking seriously about liquidity solutions.

    Kind Regards,
    Ranjan

  4. As a footnote to my previous comment, I noticed that the Liquidity Derivatives paper that I cowrote with Gunter Meissner and James Youn is available on the internet for free(not for distribution):

    http://www.caia.org/ai/journalofalternativeinvestments/

    (it is the featured article on the CAIA website, at the right side of the page, and one may access it by pressing the link which states “Read the Full Text”).

  5. Here are a few thoughts that I had about this article:

    - Given that securitization desks in banks and trading desks are separated by a “chinese wall,” how would the issuer of the bond have better knowledge of liquidity than the market?

    - How would the issuer of this instrument hedge himself? One way that I thought of, is with a put (this way when the issuer receives the stock, they have someone who is obligated to buy is from him). But figuring out the strike is problematic and buying a portfolio of puts is expensive. Any thoughts?

    - How would you know that the price moved because of the sale of this specific transaction and not some rebalancing at the end of the month by a pension fund? How would you model this — it would probably be using some proprietary data, as I do not know of any data tracking execution vs mid-price.

    This article definitely opens up the floor to a bigger discussion. Thanks!

  6. You said it yourself, this contract would be worthless except in a “liquidity event”. In that case, what we really want to be managing is the ‘more extreme form’ (vs. the less extreme form that you talk about here).

    In a situation where we’re long a stock and want to manage this risk, we want something to protect us from downside jumps (which could also be caused simply by us exiting a large position in illiquid times, the less extreme form). I recall that LOR (of portfolio insurance infamy) offered something called “jump protection” as an extra product, I don’t recall the details of implementation unfortunately.

    I think this could be accomplished with an OTM put that is restruck daily (or weekly) at VWAP. On a $100 stock (r=5%, vol=15%), a 5% OTM put restruck weekly would cost $0.20/sh per year

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