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Illiquid Assets
Liquidity has a large effect on how hedge funds work – the reason is that unlike MF”s they
are quite dynamic and end up being heavily impact if they can’t move money around
Liquidity is defined as the ease with which one can buy and sell certain securities at the
price desired without actually impacting the price itself
This is quite difficult to measure:
Bid-ask spreads – the larger the less liquid
Price impact of a large trade – selling or buying that many shares would take up
many orders in the order book, and hence the more the price changes the less liquid
the security is
Volume
Depth in a limit order book
Time between transactions
Sources of liquidity
Lack of participation
Restrictions
OTC bonds – a lot of people don’t have the rights to it
Some markets and assets are very costly
Transaction costs
Commissions, taxes, due diligence, stamp duty, brokerage etc
Search frictions
Difficult to find people to trade with
Asymmetric information
Markets can be illiquid because investors have access to different information
Traders may be concerned about a good deal when the information is asymmetrical
Price impact
Large trades may mean that the price is heavily affected, which means that the trade
will materially affect the price. The borrowing price
Funding constraints
Many investors don’t have the ability to fund the cost of certain securities or assets,
due to legal restrictions/financial restrictions etc
Survivorship bias
The issue that certain securities may not exist for the entire time during which we
determine performance. It tends to be the better and surviving assets or funds which
we can accurately measure which gives us an upward performance bias
Infrequent trading
Because we have thin trading, it will appear that there was no change in price, but
we only get snapshots of potentially broad macroeconomic effects such as
commodity price changes, exchange rates etc. This means the returns will appear to
be smoothed out. Because a price will seem static for many days, this means that for
things like the sharpe ratio, the stdev will seem lower and the mean return will seem
higher
Selection bias
It is unlikely that people will sell their assets when the market falls, lest they try to
avoid further losses. This bias is prevalent in illiquid assets because selling in general, let
alone when the market for these assets falls, is difficult (by definition). Hence the only
observed data points are when the prices go up. Expected returns will be overestimated,
and beta and volatility will be underestimated because of this thin trading issue here
These biases for illiquid securities tends to give higher alpha and lower beta
Illiquidity risk premiums exist to compensate for the difficulty in selling illiquid assets
The compensation is for:
Inability to access capital immediately (legal issues with real estate etc)
Withdrawal of liquidity in a liquidity crisis – the difficult to actually find some to buy
the asset
When pricing liquidity, we should only be focusing on the systematic liquidity risk; we are
being rewarded for market liquidity risk, as we could have diversified the other risk. We can
then develop a liquidity beta. How sensitive is a stock to market liquidity?
The liquidity beta uses a net beta, which is composed of three liquidity betas
E(Rit-Rft) = E(cit) + lambdaßi1 + lambdaßbi2-lambdaßi3-lambdaßi4
Relaxes transaction costs from the normal CAPM
In bad times people will invest in liquid securities – flight to liquidity, hence why illiquid
securities are riskier in bad times