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

- 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!

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”).

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

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.