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The era since the early 1970s might legitimately be termed as the Renaissance Period in finance. The classic work in option-pricing by Black and Scholes [1973], and Merton [1973] helped mitigate equity risk through the prudent use of equity options. In the past three decades, derivatives in interest rates, foreign exchange, weather, credit, and real estate have all grown in popularity. Each of these instruments allows for the isolation of an element of risk, and the transfer of this risk to a willing market participant. This certainly makes aggregate risk distribution more effective. By strategically conducting risk neutralization, a firm may concentrate on its core competency. Apart from market players who invoke hedging for risk management purposes, there are speculators who trade these derivatives in the belief that they have a particular insight on the direction of the underlying, as well as arbitrageurs who try to take advantage of pricing inconsistencies. This article introduces five new derivatives that allow for the reduction or elimination of liquidity risk-namely, withdrawal options, hedge fund return puts, hedge fund return swaps, hedge fund return swaption, and liquidity options.
LIQUIDITY IN THE HEDGE FUND INDUSTRY
At the current time, reducing liquidity risk is a key challenge that investors face in managing their hedge fund portfolios. With increased regulatory pressure by the sec, and an increasing commitment demanded by fund managers from their limited partners, investors face longer lock-up periods and corresponding higher liquidity risk. Further, as institutional investors, such as pension funds, continue to increase their allocations to hedge funds (assets reached $71 billion in May 2005, up from $29 billion in January 2000),' there is a growing realization of the need for derivative instruments that can effectively hedge liquidity risk.
The need for flexibility in this asset class has never been more important. The number of managers charging management fees in excess of 1% has grown to 53%, up from 41% at the end of 2005.2 With these increased fee structures, as well as other significant barriers to entry, there is a growing demand among investors to help control the risks inherent in investing in hedge funds. In this article, we will focus on liquidity risk, an area that, in recent years, has received renewed interest from academics,...