Liquidity Options

Abstract

The financial crisis of 2008 revealed how critically important liquidity is to investors in times of turmoil. When investors and financial institutions were facing huge demands for cash that they either had to meet or else declare bankruptcy, security valuation that was derived from theoretical models became completely irrelevant. Tradable securities had to be dumped on the market and sold for whatever prices they could fetch. Looking back, one wonders: Can’t anyone figure out some way to hedge this risk using derivatives? Golts and Kritzman think they have. In this article, they propose the creation of a new kind of derivative contract they call a “liquidity option.” They describe how such options could be structured with payoffs resembling those of a cliquet option tied to some broad market index, and show how they should be priced to be consistent with the market’s current valuation of liquid versus illiquid instruments.

TOPICS: Options, accounting and ratio analysis, VAR and use of alternative risk measures of trading risk