Locked Up by a Lockup: Valuing Liquidity as a Real Option
Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)
Nicolas P. B. Bollen
Vanderbilt University - Finance
October 21, 2008
Hedge funds often impose lockups and notice periods to limit the ability of investors to withdraw capital. We model the investor's decision to withdraw capital as a real option and treat lockups and notice periods as exercise restrictions. Our methodology incorporates time-varying probabilities of hedge fund failure and optimal early exercise. We estimate a two-year lockup with a three-month notice period costs investors 1.5% of their initial investment. The magnitude is sensitive to a fund's age, expected return, and the liquidation cost upon failure. The cost of illiquidity can exceed 10% if the hedge fund manager suspends withdrawals.
Number of Pages in PDF File: 49
Keywords: Cost of illiquidity, hedge fund valuation, exercise restriction, redemption notice period, lockup, suspension clause
JEL Classification: G13, G23, C63
Date posted: October 30, 2008 ; Last revised: November 17, 2012
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