Richard R. Lindsay paper

Forced Liquidations, Fire Sales, and the Cost of Illiquidity


Richard R. Lindsey & Andrew B. Weisman
Q Group
October, 18, 2015

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Once Upon a Time…

There was an (almost) magical hedge fund with high returns and low volatility…


Once Upon a Time…


But subprime mortgage delinquencies grew, and the value of securities held by the fund dropped…

Once Upon a Time…

The Prime Brokers for the fund asked for more cash collateral…

The fund tried to liquidate assets in a declining market to meet the collateral calls…

But asset values continued to decline quickly while collateral requirements continued to rise…

Once Upon a Time…

The fund failed even though its parent company attempted to stabilize it with a substantial cash injection…

Investors were returned 9₵ on the dollar…

And the managers lived happily ever after…

Portfolio Construction

Typical approach is to diversify across securities and strategies,
using the common “currencies”

Looking for low correlation and low volatility
Low volatility and correlation often an “accounting artifact”
Drawn to securities with limited price discovery

Investors tend to believe in a “liquidity premium” that compensates them for illiquidity

Liquidity in Portfolios

Lo, et al (2003)
Add liquidity as additional constraint in mean-variance optimization

Seigel (2008); Leibowitz & Bova (2009)
Consider liquidity in determining portfolio weights

Ang, et al (2011)
Optimal liquidity policy with market frictions

Kinlaw, et al (2013)
Liquidity as a shadow allocation in the portfolio

Serial Correlation & Liquidity

Illiquid portfolios tend to exhibit a high degree of positive serial correlation (Weisman (2003); Getmansky et al (2004))

Methods:Scholes & Williams (1977); Geltner (1993); Getmansky, et al (2004); Bollen & Poole (2008); Anson (2010); Anson (2013)


Adjust the time series for serial correlation Decode the performance to adjust volatility and correlations

Illiquidity: The Cost is Ignored

Primary Question:Are under-reported volatility and correlation a benign consequence of illiquidity or is there more to it?

What should concern you most as an investor?

We argue that simply adjusting for serial correlation fails to measure or capture the core risk and cost of illiquidity that investors should care about: forced liquidations and “fire sales”

Causes of Illiquidity

A mismatch between the funding of an underlying investment and the horizon over which the investment can be sold

Leverage/Financing:(Garleanu& Pedersen (2009); Brunermeier & Pedersen (2009); Office of Financial Research (2013))
–Including swaps, futures, margin

Contractual terms: (Ang & Bollen(2010))
–Gates, lock ups, notice periods

Network factors :(Battacharya, et al (2013); Gennaioli, et al (2012); Boyson, et al (2010); Mitchell, et al (2007); Chen, et al (2012); Schmidt, et al (2013))
–Common service providers (custodians, prime brokers, securities lending counterparties)
–Unanticipated strategy correlation
–Common investors

Liquidity & Reality

The true value of the portfolio assumed to follow a discrete Brownian motion:


Bayesian process of adjusting some proportion of the distance between prior period’s valuation and what it’s perceived to be worth in the current period (Quanand Quigley (1991))

Liquidity & Reality

The observed (reported) return is a function of:
–The trend rate of return
–The realized volatility
–The under/over-valuation of the prior period


Liquidity & Reality


(Not the only method for deriving this prior: common sense “sanity checks” also useful…)

Smoothed Value

How are Nt (true value) and Rt(reported value) related?

Smoothed Value

Illiquidity systematically drives under/over-valuation

Under-valuation not so critical, over-valuation more of an issue:

Interested third parties will not allow a portfolio valuation to exceed a rational tradable value by more than a “reasonable” margin

Prime brokers that extend credit, monitor reported valuations as assets serve as collateral

We refer to this margin as the “credibility threshold” (L)

L effectively determined by the first interested third party such as Prime Brokers or investors to act;

Smoothed Value


Smoothed Value

Exceeding the credibility threshold triggers forced behavior (selling)

May result in a large single period loss governed by:
The portfolio overvaluation (Rt-Nt)
A liquidation penalty (P)

Such losses relatively frequent and tend to be larger than conventional data-dependent methods such as VaR or CVaR

The magnitude and frequency (not the timing) are reasonably predictable, and can be pricedby formalizing the basic structural dynamics

Barrier Option Framework

Simulate the “true” value of portfolio using discrete BM which is a function of:
Simulate 100k times and calculate the mean NPV of all the one-year paths (including those which do not cause liquidation)
This naturally translates into a “haircut” against the observed return and represents a de facto price for investing in a less liquid portfolio

Option Value: L & λ


Option Value: P & λ


Option Value: P & L


Option Sensitivities


Additional Considerations

The option value is not a liquidity premium, rather it is the calculated cost of price smoothing an illiquid portfolio when combined with a triggering event, that may result in an abrupt sale into a declining market

When the portfolio is illiquid, managers generally do not have the flexibility to avoid these dynamics

Parameter Considerations

In cases of fraud or collapse, transactions in the secondary market for hedge funds have an average discount to NAV
of 49.6% (Ramadorai(2008))

JPMorgan (2012)
Hedge funds expected return 5% to 7%
Hedge funds expected volatility 7% to 13%

Private equity expected returns 9%
Private equity expected volatility 34.25%

Are these sufficient returns given the volatility?

Pricing Liquidity in Alternative Investments (Indices)


Measured serial correlation for most of these lie in the 50% to 60% range

Managers are typically reflecting less than 50% of the true change in the value of their portfolios

Depending on assumptions concerning other parameters, the option value could be quite significant!

Example: Emerging Market liquidity option: 13.52%Observed return: 17.3%, Liquidity-adjusted return: 3.78%

Pricing Liquidity in Alternative Investments (Funds)

Morningstar-CISDM Hedge Fund Database (contains both live and dead funds)
Eliminated CTAs and Fund of Funds
At least 24 months of return history
Autocorrelation of 0.01 or higher
Eliminate the last 3 months of data for each manager

3,554 hedge funds
Average Option value was 5.52%Implying an average Liquidity-adjusted mean return of 6.27%

Pricing Liquidity in Alternative Investments (Funds)


Option Values vs Drawdowns


The Poster Child

The (almost) magical fund: Bear Stearns High-Grade Structured Credit Strategies

µ=12.4%    σ=1.5%    λ=0.3635

Option value close to $0, but…

The standard deviation for the HFRI Fixed Income–Asset Backed Index: 4.03%

The Bear Stearns Fund was showing ≈ 1/3 of the index volatility

The Poster Child

As the fund’s volatility approached the index volatility, the option cost exploded


Summary & Conclusion

Adjusting for serial correlation fails to measure or capture the core risk and cost of illiquidity: forced liquidations and “fire sales”

A barrier option model provides a straight-forward method of combining priors about the market to price this core risk