|Locked Up by a Lockup: Valuing Liquidity as a Real Option|
|Financial Management 39, p.1069-1095, 2010
|Nicolas P.B. Bollen and Andrew Ang|
Hedge funds often impose lockups and notice periods to limit the ability of investors to withdraw capital. We model the investorís decision to
withdraw capital as a real option and treat lockups and notice periods as exercise restrictions. Our methodology incorporates time-varying
probabilities of hedge fund failure and optimal early exercise. We estimate a two-year lockup with a three-month notice period costs approximately
1% of the initial investment for an investor with CRRA utility and risk aversion of 3. The magnitude is sensitive to a fundís age, expected return,
volatility, and the liquidation cost upon failure. The cost of illiquidity can easily exceed 10% if the hedge fund manager suspends withdrawals.