Andrew Ang

Locked Up by a Lockup: Valuing Liquidity as a Real Option

Coauthor(s): Nicolas P. B. Bollen.

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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.

This is the pre-peer reviewed version of the article, which has been published in final form at Financial Management.

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