A Theory of Managing the Liquidity Transformation Risks from Stale Pricing

Abstract

This paper provides a simple two-period model to formalize and add structure to the economic intuition discussed in Couts (2025). It was originally included in an earlier version of that paper. As quoted in Couts (2025), "Open-end funds provide a liquidity transformation service by issuing and redeeming shares that are more liquid than their assets. However, because these assets are illiquid, managers need time to transfer capital to the underlying market. Liquidity buffers and liquidity restrictions enable this. Additionally, because of this illiquidity, their returns are predictable and susceptible to NAV-timing strategies that transfer wealth. I show that NAV-timing strategies appear profitable on paper and investors appear to follow these strategies. I also show liquidity restrictions provide a secondary benefit of protecting against these NAV-timing risks while liquidity buffers do not. In fact, liquidity buffers amplify them when added to liquidity restrictions."

Keywords: JEL Classification: G11, G12, G13, G14, G17, G23, R33 Fair Valuation, Financial Fragility, NAV-timing, Real Estate