Estimating the Marketability Discounts: A Comparison between Bid-Ask Spreads, and Longstaff's Upper Bound
Journal of Applied Finance, Spring/Summer 2013, Volume 23, No. 1
Posted: 16 Jul 2013
Date Written: July 15, 2013
This paper contends that the discount for lack of marketability (DLOM) is the difference between the stock price of a liquid company and an equivalent illiquid company and reflects the lack of a free-trading option that is embedded within a company’s stock. Longstaff derived a model that views this liquidity swap as a lookback option. We equate this option to the Bid-Ask spread of a stock consistent with the market microstructure literature. We construct a model for the DLOM using the Longstaff (1995) metric and the Bid-Ask spread of Over-the-Counter Bulletin Board stocks as a proxy. We find that our spread-based model does a better job of predicting restricted stock discounts than the Longstaff metric. We include a case study on two companies to illustrate our methodology.
Keywords: discount for lack of marketability (DLOM), lookback option, market microstructure, bid-ask spread
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