reading 37:discuss capture of the illiquidity premium as an investment objective;

CFA Level III Portfolio Management
#1

Hi,

CFAI book 6, page 297, regarding the LOS "discuss the capture of illiquidity premium as an investment objective"

Text states: An alternative approach for estimating the illiquidity risk premium is based on the idea that the size of the discount an investor should receive in return for committing capital for an uncertain period of time can be represented by the value of a put option with an exercise price equal to the marketable price of the illiquid asset at the time of purchase.

say I am a wealthy investor, I agree to invest in an illiquid asset ‘worth $100’ today, to do so, I expect its value to raise to $150 in 5 years for example. It is like purchasing a put option with strike=$150.

Am i understanding this point? Could anyone offer a better explanation?

thanks

#2

Let’s say X is the illiquid asset for which the price we are trying to determine.

And let’s say we have Y, which is similar to X except that it is marketable, and Y has a price of $100 today (i.e. the marketable price).

So the difference between the price of X and Y should be attributable to the illiquidity premium (given everything else is the same).

What they are proposing is the illiquidity premium is represented by the value of the put option on the asset where the strike price is equals to $100 (i.e. the marketable price). So, let’s say the value of the put option is $5.

You can interpret the $5 as the illiquidity premium (i.e. the minimum compensation the investor requires to invest in the illiquid asset, X). Hence, the price of X should be $100 - $5 = $95.

Or, you can also think of the $5 as an insurance premium that the investor is willing to pay to convert an illiquid asset into a liquid asset (protection against price dropping below $100).

1 Like
#3

thank you Fabian

#4

I am also trying to understand the same concept

Can we say that for you to be able to pay your illiquid asset at $100 ( the strike price), you need to pay $5 dollar upfront because you are dealing with an asset that is not tradeable? But I don’t get why we are saying that $95 is the price of illiquid asset

#5

I like the concept of a $5 insurance premium to convert an illiquid asset into a liquid asset, but I don’t quite track how it fully converts. Now you have a quasi call option where I assume the value of the illiquid asset tracks the liquid asset
e.g. A - liquid asset drops to $80 → you make $20 on the put option and lose $20 on the illiquid asset
B - liquid asset increases to $120 → you don’t make anything on the put option and make $20 on the illiquid asset