Liquidity Options

The financial crisis of 2007-2009 highlighted to many investors the importance of liquidity. University endowment funds,for example, were forced to sell publicly traded securities at substantially depressed values in order to meet funding commitments to private investments. Hedge funds engaged in lire sales of-publicly traded securities to meet margin calls from lenders and redemption demands from clients. And financial institutions faced with capital calls sold assets at substantial discounts to their government-guaranteed values. Investors could guard against these capital calls by maintaining a reserve of liquid securities, but this protection would require them to sacrifice the expected return premium of less-liquid investments. We propose, as an alternative, that investors consider purchasing liquidity options to meet unscheduled capital calls. We describe how to structure and price liquidity options, and we demonstrate how the price discovery process of liquid securities determines the fair value of illiquid securities.