Locked Up by a Lockup: Valuing Liquidity as a Real Option |
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| Authors: | Andrew Ang Nicolas PB Bollen |
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| Institution: | 1. Andrew Ang is the Ann F. Kaplan Professor of Business at the Columbia Business School, Columbia University in New York, NY.;2. Nicolas P.B. Bollen is the E. Bronson Ingram Professor of Finance at the Owen Graduate School of Management at Vanderbilt University in Nashville, TN. |
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| Abstract: | 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. |
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