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Locked Up by a Lockup: Valuing Liquidity as a Real Option
Author(s) -
Ang Andrew,
Bollen Nicolas P.B.
Publication year - 2010
Publication title -
financial management
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.647
H-Index - 68
eISSN - 1755-053X
pISSN - 0046-3892
DOI - 10.1111/j.1755-053x.2010.01104.x
Subject(s) - notice , market liquidity , hedge fund , hedge , business , risk aversion (psychology) , actuarial science , investment (military) , capital (architecture) , economics , financial economics , monetary economics , finance , expected utility hypothesis , history , ecology , archaeology , politics , political science , law , biology
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.