Defending the “Endowment Model”: Quantifying
Liquidity Risk in a Post–Credit Crisis World

Abstract

This article sets forth the proposition that liquidity risk may be optimized in an attempt to forestall or minimize the impact of a liquidity crisis. For a generic (but typical) endowment asset allocation, the authors find that liquidity levels between 6% and 14% are optimal, all other things equal, because 95% of the time, an allocation in this range would obviate situations in which a portfolio’s payout rate exceeds its liquidity pool. The framework also provides insights for tail-risk events involving a particularly severe liquidity crisis. For a generic endowment portfolio, the analysis indicates that in order to reduce the severity of a liquidity crisis to zero (i.e., eliminate risk completely), the allocation to fixed income would have to be around 35% (close to seven times the payout rate of 5%). Such an allocation would entail a very significant opportunity cost in terms of forgone returns based solely on a desire to mitigate extreme liquidity events (the proverbial “100-year flood”). In the authors’ view, reducing the likelihood of a liquidity crisis to below 5%, may be undesirable for all but the most risk-averse and least returnsensitive endowments.