Locked Up by a Lockup: Valuing Liquidity as a Real Option

49 Pages Posted: 30 Oct 2008 Last revised: 17 Nov 2012

Andrew Ang

BlackRock, Inc

Nicolas P. B. Bollen

Vanderbilt University - Finance

Multiple version iconThere are 4 versions of this paper

Date Written: October 21, 2008

Abstract

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.

Keywords: Cost of illiquidity, hedge fund valuation, exercise restriction, redemption notice period, lockup, suspension clause

JEL Classification: G13, G23, C63

Suggested Citation

Ang, Andrew and Bollen, Nicolas P. B., Locked Up by a Lockup: Valuing Liquidity as a Real Option (October 21, 2008). Available at SSRN: https://ssrn.com/abstract=1291842 or http://dx.doi.org/10.2139/ssrn.1291842

Andrew Ang

BlackRock, Inc ( email )

55 East 52nd Street
New York City, NY 10055
United States

Nicolas P.B. Bollen (Contact Author)

Vanderbilt University - Finance ( email )

401 21st Avenue South
Nashville, TN 37203
United States

HOME PAGE: http://mba.vanderbilt.edu/faculty/nbollen.cfm

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