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
Financial Management, Vol. 39, No. 3, pp. 1069-1096, November 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 approximately 1% of the initial investment for an investor with constant relative risk aversion utility and risk aversion of three. The cost of illiquidity can easily exceed 10% if the hedge fund manager can arbitrarily suspend withdrawals.
Number of Pages in PDF File: 49
Date posted: October 21, 2011