Thread by @KrisAbdelmessih

Locking up your $$ to save you from yourself is a sales pitch in some parts.

I've said before:

"Any argument that says liquidity is bad because it exposes you to behavioral bias must address the value of that option."

Let's explore this.

First, why care?

Even if you want to lock up your $$ to "save you from yourself", that doesn't mean you don't deserve a discount for investing in something illiquid.

Your needs/preferences don't set the marginal price.

Don't be so vain, not everything is about you 🎶

The price of an illiquid investment are set by those who do care about liquidity even if you don't.

You inherit that discount the same way you get power windows for free nowadays. You get that even if you think you'd be better off with the exercise of cranking your own windows.

So all else equal (I know it never is), illiquidity deserves a discount or liquidity deserves a premium. It's all relative.

3 things I've come across recently have made wonder about how big a liquidity premium is warranted.

Let me just list those first...

1. A paraphrase of @Jesse_Livermore:

High valuations are increasingly dependent on liquidity or what he terms "networks of confidence".

He refers back to prior work that shows how you'd need a healthy discount to intrinsic to buy an asset you couldn't sell.

He poses a cool thought experiment where you price an asset that has no fundamental risk but unpredictable, perhaps zero liquidity in the future even though you can count on its dividend.

https://twitter.com/Jesse_Livermore/status/1313901764169564161?s=20

2. Then I came across the EE bond article which showed how a feature of these treasury issued bonds is, if held for 20 years, you are guaranteed 2x your money back.

So worst case you earn 3.5% CAGR nominally.

But they don't trade in an open market.

Meanwhile...

Liquid US treasuries trade for about 1.5% yield.

Let's set aside the fact that one can only buy $10k worth of EE bonds per year.

There is a 2% per year difference in yield if you held both to maturity. Is that big or not?

Let's see one more example.

3. Insurance products

I know someone who is considering jamming a bunch of $$ into an insurance product that "guarantees" around 3.5% per year if held for about 25 years.

I don't want to turn this into a thread about insurance (I have enough brain damage from the email thread)

The larger point is there are products where you can earn more yield for sacrificing liquidity

(regardless of what that higher number is after dissecting credit, actuarial etc.

PSA: If you are interested in insurance wonk stuff follow @RajivRebello).

So...

We know we should be willing to pay a premium for liquidity all else equal.

How big should the premium be? How do we start to think about this.

Here's 2 general frameworks for a starting point.

1. Replication Approach

What's the obvious advantage of liquidity?

You can cut risk.

The fact that a market is willing to show you a bid for your investment at all times has a real theoretical value. In fact, the entire options market is built upon that idea.

Let's go back to the untradeable EE bond vs the 20 year treasury.

The nominal EE bond has a nominally guaranteed CAGR of 3.5% if held to maturity. But it's real return is not guaranteed. In real terms you can technically lose 100%

Meanwhile...

The liquid bond can be sold. If you placed a stop order on it, you can create one of those hockey stick payoff diagrams where the most you can lose is your stop price.

So...you have created an option. This was the entire basis of portfolio insurance.

[reader recoils 🤮]

I know, I know.

1987 ruined the term "portfolio insurance". But the reality is some version of it is done every time a MM sells an option and delta hedges it.

The MM is trying to dynamically replicate the option they have sold. They are "manufacturing" a long option.

The MM hopes the accumulation of losses due to negative gamma (buying high and selling low) is less than the premium they collected up front for the option.

🗝️The key here is to recognize that the ability to "manufacture" an option by trading is possible because of liquidity.

Yes the manufactured option fails in the presence of gaps. It's not as valuable as "hard" or contractual optionality.

1987 in fact makes my point...the constraint on theory is actual liquidity.

Liquidity is valuable in itself because it sustains options (and options are good)

(aside: options are valuable because they allow you to fine tune risk. Slice & dice the expressions of your desired exposure or lack of exposure. Equity is an option. Cap structures allocate options according to what shape of risk people are willing to take)

Back to the bonds...

So we can think of a liquid bond as having an option to sell that the EE bond does not.

Liquid bond = EE bond + Option

Pricing the option (if we assume the market is continuous) will be an exercise in portfolio insurance-esque replication.

* Pick some theo strike (ie maybe a desired stop price)

* Estimate what option is worth

* Add it to the cost of an EE bond that guarantees 3.5%
for 20 yrs.

⚖️Compare that portfolio to a 1.5% yield and you are taking a big step toward quantifying the value of liquidity.

Back to this concept:

Liquid bond = EE bond + Option

What is the main driver of the option's value?

Volatility.

So the premium we are willing to pay for liquidity depends on volatility!

So, the more volatile the future is, the bigger the discount we should ascribe to illiquid assets.

(With implied vols relatively elevated, private investing should be worth less if all else is equal. Perfectly reasonable to argue that's where the alpha is of course).

The main point of framework 1:

💡Increased volatility raises the value of liquidity because it raises the value of the option embedded in the ability to trade.

[sips coffee]

I mentioned there's a second framework for valuing the premium we can ascribe to liquidity.

2. Rebalancing premium

The ability to rebalance your portfolio is valuable.

A simple example:

Markets take a dive. Pretend 1/2 your wealth was in stocks and 1/2 in your home

If homes were down more than stocks. You could sell stocks & upgrade your home while restoring 50/50.

I've shared my example of rebalancing between a coin flipping investment with edge with a fair coin to confirm the results quants understand: rebalancing pushes your geometric return up towards the expected arithmetic return.
(remember geo returns are lower bc of variance drain)

What drives the re-balancing premium?

Volatility and correlation.

The size of it is a function of volatility (variance drain is .5 x variance) and this should be satisfying:

The option replication framework also said that volatility increases the value of liquidity.

The correlation part and a real dive into rebalancing premium is well covered by @breakingthemark in his blog. His recent post shows how lower fees/spreads provide unprecedented opportunity to capture "Shannon's Demon"

breakingthemarket.com/the-great-age-…

This was a long thread.

Takeaways:

✔️The higher the vol, the more liquidity is worth.

✔️Option replication & rebalance are 2 ways value liquidity

✔️You should get a better deal for accepting low liquidity