Valuing a Lost Opportunity: An Alternative Perspective on the Illiquidity Discount

Introduction

• Authors: Jamil Baz, Christian Stracke, Steve Sapra
• Focus: Examining the illiquidity discount from the perspective of opportunity cost.

Executive Summary

• Illiquidity discount is a compensation for tying up capital in illiquid investments.
• Investors lose the ability to take future opportunities when committing to locked-up funds.
• The discount should reflect the investor’s skill and ability to generate alpha.
• Typical illiquidity discounts range from 1.5% to 2% per year, higher for skilled investors.

Illiquidity Premium

• Originates from a price gap set by investors to compensate for capital lock-up.
• Supported by theories from Keynes and subsequent research.
• Justifications include clientele effects, transaction costs, portfolio inefficiency, and opportunity cost.

Framework for Quantifying Illiquidity Discount

• Modeled through the opportunity cost of foregone alpha.
• Two alpha sources: continuous (selection/timing) and jump (rare market opportunities).
• Illiquidity discount depends on the perceived alpha landscape.
• Typical discounts for skilled investors range from 4.1% to 7.2% per year.

Methodology

• Liquid assets allow for flexibility in exploiting market opportunities.
• Illiquidity discount modeled using alpha processes: continuous (OU process) and jump (Poisson process).
• Equations for calculating the total alpha opportunity and its impact on the discount.

Model Estimation

• Parameters estimated based on historical alpha and its variance.
• Continuous alpha estimated via futures trading strategies.
• Jump component estimated through stress-event buying strategies.
• Example of Warren Buffett used to illustrate high-skill investor scenarios.

Behavioral Perspective

• Illiquidity discount reflects perceived, not actual, alpha-generating ability.
• Overconfidence in skills may lead to inflated illiquidity discounts.

Discussion

• Opportunity cost is the main justification for illiquidity discounts.
• Illiquidity discount is countercyclical; higher during recessions.
• Empirical data supports variations in discounts based on economic conditions.

Conclusion

• Illiquidity discounts compensate for the inability to exploit future opportunities.
• Discount levels reflect perceived opportunities and are highest during recessions.

References

• Cited works include studies on liquidity, asset pricing, and economic theories.

Appendix

• Detailed equations and processes for calculating liquidity premium.