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
January 16, 2009
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 approximately 1% of the initial investment for an investor with CRRA utility and risk aversion of 3. The magnitude is sensitive to a fund's age, expected return, volatility, and the liquidation cost upon failure. The cost of illiquidity can easily exceed 10% if the hedge fund manager suspends withdrawals.
Number of Pages in PDF File: 40
Keywords: hedge fund lockup, withdrawal, redemption notice period, suspension clause
JEL Classification: G23, G13
Date posted: March 11, 2009
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