Research puts price on hedge fund “illiquidity premium”

May 6th, 2008 | Filed under: CAPM / Alpha Theory, Guest Posts | By:
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Liquidity (or lack thereof) is a perennial issue in the hedge fund industry.  How much should investors expect to be compensated for the lock-ups that hedge funds often require?  And does such a premium really count as “alpha”?  Pierre Laroche of Innocap Investment Management (see related posting on Innocap’s hedge fund replication work) tells us of a study he recently conducted that comes to a pretty definite conclusion about the illiquidity premium.  Laroche is the co-author of three books on derivatives and risk management.

Special to AllAboutAlpha.com by: Pierre Laroche, Managing Director – R&D Innocap Investment Management

Much has been done in recent years to better measure and price illiquidity.  These developments had a positive impact on risk management practice.  For example, some interesting liquidity-adjusted VAR models have been developed recently.  There has also been quite a bit of discussion on this topic on the pages of AllAboutAlpha.com (e.g. “Liquidity Alpha“, “Liquidity Insurance“)

At Innocap, we recently finished an interesting study that proposes a way to quantify the cost of illiquidity and adjust the risk-return profile of an illiquid asset.

Our model aims at reproducing the trading methods and market environment of typical (median) CTA hedge funds. (We could have chosen other types of hedge funds.  This one is used for illustrative purposes only).  The model integrates the impact of liquidation delays, accrued bid-ask spread (BAS hereafter) and increased volatility (feedback effect). This is an improvement over other models, which only take into account one or two of these factors.

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