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We present a model of optimal allocation over liquid and illiquid assets, where illiquidity is the restriction that an asset cannot be traded for intervals of uncertain duration. Illiquidity leads to increased and state-dependent risk aversion, and reduces the allocation to both liquid and illiquid risky assets.
- 614KB
- Andrew Ang, Dimitris Papanikolaou, Mark M. Westerfield
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- 2014
Nov 5, 2024 · Liquid assets are assets that can be quickly converted into cash with minimal effort and without significant loss of value. They play an important part in a company's or individual's financial health by ensuring liquidity, which is the ability to meet short-term obligations without affecting ongoing business operations. Examples of Liquid Assets
- Marketability and Value: Measuring the Illiquidity Discount
- Measuring Illiquidity
- Transactions Costs on Publicly Traded Assets
- The Bid-Ask Spread
- Why is there a bid-ask spread?
- 1. The Inventory Rationale
- 2. The Processing Cost Argument
- 3. The Adverse Selection Problem
- The Determinants of the Bid-Ask Spread
- The Price Impact
- Why is there a price impact?
- How large is the price impact?
- The Opportunity Cost of Waiting
- The Cost of Illiquidity: Theory
- Illiquidity and Discount Rates
- The Cost of Illiquidity: Empirical Evidence
- Publicly Traded Stocks
- Dealing with Illiquidity in Valuation
- Illiquidity Discounts on Value
- b. Firm-specific Discount
- Estimating Firm-Specific Illiquidity Discount
- Adjusting Discount Rates for Illiquidity
- Relative Valuation
- 2. Relative Valuation with Illiquidity Discount
- The Consequences of Illiquidity
- Going Public (Private)
- Portfolio Management
Aswath Damodaran Stern School of Business July 2005 Marketability and Value: Measuring the Illiquidity Discount Should investors be willing to pay higher prices for more liquid assets than for otherwise similar assets that are less liquid? If the answer is yes, how much should the premium be for liquid assets? Conversely, how do we estimate the dis...
You can sell any asset, no matter how illiquid it is perceived to be, if you are willing to accept a lower price for it. Consequently, we should not categorize assets into liquid and illiquid assets but allow for a continuum on liquidity, where all assets are illiquid but the degree of illiquidity varies across them. One way of capturing the cost o...
There are some investors who undoubtedly operate under the misconception that the only cost of trading is the brokerage commission that they pay when they buy or sell assets. While this might be the only cost that they pay explicitly, there are other costs that they incur in the course of trading that generally dwarf the commission cost. When tradi...
There is a difference between what a buyer will pay and the seller will receive, at the same point in time for the same asset, in almost every traded asset market. The bid-ask spread refers to this difference. In the section that follows, we will examine why this difference exists, how large it is as a cost and the determinants of its magnitude.
In most markets, there is a dealer or market maker who sets the bid-ask spread, and there are three types of costs that the dealer faces that the spread is designed to cover. The first is the cost of holding inventory; the second is the cost of processing orders and the final cost is the cost of trading with more informed investors. The spread has ...
Consider a market maker or a specialist on the floor of the exchange who has to quote bid prices and ask prices, at which she is obligated to execute buy and sell orders from investors. These investors, themselves, could be trading because of information they have received (informed traders), for liquidity (liquidity traders) or based upon their be...
Since market makers incur a processing cost with the paperwork and fees associated with orders, the bid-ask spread has to cover, at the minimum, these costs. While these costs are likely to be very small for large orders of stocks traded on the exchanges, they become larger for small orders of stocks that might be traded only through a dealership m...
The adverse selection problem arises from the different motives investors have for trading on an asset - liquidity, information and views on valuation. Since investors do not announce their reasons for trading at the time of the trades, the market maker always runs the risk of trading against more informed investors. Since the expected profits from...
A number of studies have looked at the variables that determine (or, at the very least, correlate with) the bid-ask spread. Studies6 find that the spread as a percentage of the price is correlated negatively with the price level, volume and the number of market makers, and positively with volatility. Each of these findings is consistent with the th...
Most investors assume that trading costs become smaller as portfolios become larger. While this is true for brokerage commissions, it is not always the case for the other components of trading costs. There is one component where larger investors bear more substantial costs than do smaller investors and that is in the impact that trading has on pric...
There are two reasons for the price impact, when investors trade. The first is that markets are not completely liquid. A large trade can create an imbalance between buy and sell orders, and the only way in which this imbalance can be resolved is with a price change. This price change that arises from lack of liquidity, will generally be temporary a...
There is conflicting evidence on how much impact large trades have on stock prices. On the one hand, studies of block trades on the exchange floor seem to suggest that markets are liquid and that the price impact of trading is small and is reversed quickly. These studies, however, have generally looked at heavily traded stocks at the New York Stock...
The final component of trading costs is the opportunity cost of waiting. An investor could reduce the bid-ask spread and price impact costs of trading by breaking up large blocks into small blocks and trading over a longer period. If, in fact, there was no cost to waiting, even a large investor could break up trades into small lots and buy or sell ...
The notion that investors will pay less for illiquid assets than for otherwise similar liquid assets is neither new nor revolutionary. Over the last two decades researchers have examined the effect of illiquidity on price using three different approaches. In the first, the value of an asset is reduced by the present value of expected future transac...
In conventional asset pricing models, the required rate of return for an asset is a function of its exposure to market risk. Thus, in the CAPM, the cost of equity is a function of the beta of an asset, whereas in the APM or multi-factor model, the cost of equity is determined by the asset’s exposure to multiple sources of market risk. There is litt...
If we accept the proposition that illiquidity has a cost, the next question becomes an empirical one. How big is this cost and what causes it to vary across time and across assets? The evidence on the prevalence and the cost of illiquidity is spread over a number of asset classes. In this section, we will begin by considering the price attached to ...
If liquidity becomes more of an issue with riskier bonds than with safer bonds, it stands to reason that it should a bigger factor in the equity market (where there are more sources of risk) than the bond market. Studies of illiquidity in the equity market have run the gamut ranging from examining differences in liquidity across the broad cross sec...
Both the theory and the empirical evidence suggest that illiquidity matters and that investors attach a lower price to assets that are more illiquid than to otherwise similar assets that are liquid. The question that we face when valuing assets then is to how best show this illiquidity. In this section, we consider three alternatives. The first is ...
In conventional valuation, there is little scope for showing the effect of illiquidity. The cashflows are expected cashflows, the discount rate is usually reflective of the risk in the cashflows and the present value we obtain is the value for a liquid business. With 62 Krainer, J., M.M. Spiegel and N. Yamori, 2004, Asset Price Declines and Real Es...
Much of the theoretical and empirical discussion in this paper supports the view that illiquidity discounts should vary across assets and business. In particular, with a private company, you would expect the illiquidity discount to be a function of the size and the type of assets that the company owns. In this section, we will consider the determin...
While it is easy to convince skeptics that the illiquidity discount should vary across companies, it is much more difficult to get consensus on how to estimate the illiquidity discount for an individual company. In this section, we revert back to the basis 66 For more on the value of control, see the companion (http;//www.damodaran.com: Look under ...
The other approach to dealing with illiquidity is to adjust the discount rate used in discounted cashflow valuation for illiquidity. In practical terms, this amounts to adding an illiquidity premium to the discount rate and deriving a lower value for the same set of expected cashflows. Earlier, we presented asset pricing models that attempt to inco...
The valuation adjustments that we have talked about so far are structured around intrinsic valuation, where we try to estimate the value of a business based upon its cashflows and a risk-adjusted discounted rate. In practice, most valuations of both private and publicly traded companies are relative valuations, where we value businesses, based upon...
In most private company valuations, it is difficult to get a subset of comparable private businesses where there have been recent transactions. Analysts often have to use a subset of publicly traded firms as comparable firms, derive a multiple of revenues or earnings from these firms and then modify this multiple to value their private business. Th...
Illiquidity has consequences for almost every aspect of finance. The question of whether a company should go public may ultimately represent a trade off between the control (associated with being the owner of a private business) with the liquidity of becoming a publicly traded firm. Investors, be they portfolio managers, private equity investors or...
The question of whether a growing and successful private company should go public does involve trade offs. It is true that publicly traded firms have more access to capital and provide more liquidity to their owners. It is also true that the owners of private businesses have far more control on how much information they reveal to markets and how th...
If illiquidity represents a drag on value, investors have to examine its consequences when choosing investments and developing trading strategies as well as when evaluating portfolio performance. Consider the consequences for investment choices first. If, as the evidence seems to indicate, less liquid stocks generate higher expected returns over ti...
For example, average yield spreads of these matched pairs between old illiquid and young liquid bonds fall to -0.3% (-0.2%) following the announcement of Lehman Brothers’ bankruptcy (the COVID pandemic), suggesting that liquid bonds were in fact cheaper than illiquid bonds during the time of distress. Throughout
Assets that cannot be bucketed into one of the conventional investment types, such as equities, bonds and cash. Returns to these alternative assets are often uncorrelated or less correlated to traditional assets Liquid Assets • Currencies • Commodities Illiquid Assets • Real Estate • Infrastructure Alternative Strategies
the portfolio may contain some less-liquid private assets. In contrast, investors who state that their portfolios are not very liquid have less confidence they will always be able to meet all their obligations. We propose a public-private asset allocation framework that incorporates the characteristics of common illiquid private assets
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This paper is concerned with the problem of optimal asset allocation and consumption in a continuous time model when one asset cannot be traded. This illiquid asset, which depends on an uninsurable source of risk, provides a liquid dividend. In the case of human capital we can think about this dividend as labor income.
