Hedge Fund Portfolio Management with Illiquid Assets

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1 EHL Finance&Real Estate Research Seminar - Lausanne - April 15th 2016 Discussion on: Hedge Fund Portfolio Management with Illiquid Assets By: S. Darolles and G. Rousselet University of Paris-Dauphine and CREST NYU Stern Business School E. Jurczenko EHL Emmanuel.jurczenko@ehl.ch

2 Motivation of the Article Hedge funds are exposed to two types of liquidity risk Funding liquidity risk through capital and margin calls (liability side) Market liquidity risk through their investments in illiquid assets (asset side) While those two risks are linked and can lead to selfreinforcing destabilizing dynamics (see fire sales and margin/loss liquidity spirals) most of the existing empirical studies are considering them separately at odds with ALM Hfds practices The aim of this article is to study the optimal liquidity risk management strategy of a hedge fund when its investments are jointly exposed to funding and market liquidity risks

3 The Model The Opportunity Set Two-period setting Two assets (cash and one risky illiquid asset that can be traded on a secondary market) Gross asset rates are known ex-ante No leverage (equity financing only) Liquidity Risks Funding risk modelled as a random capital outflow (investors redemption) at the end of the first period Market Liquidity risk modelled as a random rebate (forced liquidation) applied on the illiquid asset price/return at the end of the first period Funding and market liquidity shocks are assumed to be independent

4 Main Results of the Article (work in progress) Solve (closed-form and numerical) the initial optimal cash allocation policy of a representative hedge fund and provide the associated fund optimal default probability and expected return/value Main results: Justify the use of stricter withdrawal restrictions (lock-ups, short notice redemption periods and gates) Show that the optimal cash buffer is decreasing in the secondary market liquidity (substitution effect) Find that the optimal fund s default probability is a bell-shaped function of the market liquidity (substitution effect) Provide an explicit estimate of the cost of illiquidity coming from the asset and liability liquidity management (lay the ground for building a new liquidity pricing factor)

5 Comments, Remarks and Questions Is the independence of the funding and market liquidity shocks realistic? If acceptable for a small hedge fund, less realistic for a mega-hedge fund (see LTCM August 98, Quant Meltdown August 07, Lehman Brothers bankruptcy September 08,.) Do not seems to be supported by your data (panel b and c, figure 4) Is the independence of the illiquid asset return with the market liquidity shock realistic? The market illiquity has only a negative impact on the return of the illiquid asset through the secondary price rebate But an increase of market illiquidity can also be associated with an increase of the ex-ante illiquidity risk premium earned on the residual investment in the risky asset The net effect of the market illiquidity on the fund expected value might be reduced

6 Comments, Remarks and Questions Why not considering leverage? Repo borrowing, short selling and derivatives are important for Hfds Margin Requirements by Security Type (as of March 2010) Source: Ang et al. (2011)

7 Comments, Remarks and Questions Is it possible to extend your framework to a multiperiodic setting? Take into account the possibility of margin and loss liquidity spirals (see Brunnermeier and Pedersen, 2009) Determine the price and structure of liquidity options to meet unscheduled capital calls in the spirit of Golts and Kritzman (2012) and and Hayes et al. (2016)

8 Relevant Literature Ang A., S. Gorovyy and G. Ingewen, (2011), Hedge Fund Leverage, Journal of Financial Economics 102, Aragaon G. and P. Strahan, (2012), Hedge Funds as liquidty Providers: evidence from the Lehman Bankruptcy, Journal of Financial Economics 103, Brunnermeier M. and L. Pedersen, (2009), Market Liquidity and Funding Liquidity, Review of Financial Studies 22, Golts M. and M. Kritzman, (2010), Liquidity Options, The Journal of Derivatives fall, Kandhani A. and A. Lo, (2011), What Happened to the Quants in August 2007?, Evidence from Factors and Transaction Data, Journal of Financial Markets 14, Lindsey R. and A. Weisman, (2016), Forced Liquidations, Fire sales, and the Cost of Illiquidity, Journal of Portfolio Management Winter, Mitchell M. and T. Pulvino, (2012), Arbitrage Crashes and the Speed of Capital, Journal of Financial Economics 104,

9 EHL Finance&Real Estate Research Seminar - Lausanne - April 15th 2016 Discussion on: Hedge Fund Portfolio Management with Illquid Assets Thanks for your attention... Discussion by: Emmanuel Jurczenko EHL Emmanuel.jurczenko@ehl.ch

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