The Value of Liquidity from the Hedge Fund Portfolio Manager’s Perspective

Abstract

Most recent articles on the value of liquidity try to answer the following question: “What additional return should investors earn to compensate for the liquidity risk they take?” In this article, the authors propose a model that prices liquidity from the portfolio manager’s perspective. The authors focus on the case of hedge fund managers, because the liquidity of hedge funds has been an important issue during the recent financial crisis, as managers have struggled with an important flow of redemption orders. The authors find that under normal market conditions, a liquidity risk premium of at least 50 basis points per year can be justified. More volatile and illiquid conditions justify a much higher premium. The authors’ results are consistent with the idea that liquidity is a sort of put option on the illiquid asset and are also consistent with recent empirical findings.