Illiquidity Premiums Market Analysis - Statistics Project Example

Illiquidity Premiums INTRODUCTION Within the stock/bond markets, illiquidity is thought as the cost of a buyer’s remorse; it can be interpreted as the cost of reversing an asset into cash immediately after the trade has been made. Thus, illiquidity is defined with the consideration that all assets are illiquid. The difference between assets is continuum as some assets appear to be more illiquid than others. A simplistic view of firms is that publicly traded firms are liquid while non-publicly traded firms are not. Assets are defined with reference to their specific components of trading costs which include brokerage cost, bid-ask spread, price impact, and opportunity cost. With this in mind, an event study is considered the measure of impact of an event on a security value (MacKinlay, 1993). Considering the components of an asset cost, an event study further explores the availability and access of information and the immediacy of impounding such info onto prices. Events are characterised by variables such as short-horizon event studies that consider limited period, habitually hours to weeks and particular to the event at hand. Short-run events yield small returns and facilitate time to focus on information being released. Long-horizon event studies are problematic in that they are sensitive to the modeling assumption of the desired returns. The basic setup for an event study involves the identification of an event and the window, selection of a security, specifying and estimating the reference model characterizing the normal returns (expected returns). However, in order to estimate accurately whether illiquid premiums exist, the characters of liquid premiums must be established first. Thus, in order to test whether illiquid premiums exist, this paper aims at answering the research question, do stocks with higher illiquidity earn higher returns?, by the analysis of two events involving bond buyers? The paper analyzes the factors that affect security markets and identifies conditions that promote illiquidity premiums. Hypothesis Considering the theory on illiquid discounts, the risk-return model, and empirical study, illiquid discount should increase with increasing trading costs; illiquidity will increase when the market is down, and assets considered less liquid have historically had higher returns (Debondt & Thaler, 1985). Body Liquidity Premium Considering the fair market value of a security, a premium that investors will demand only when it can easily be converted into cash is referred as liquidity premium. When the liquid premium is considered too high, then the asset is said to be illiquid. From the scenarios involving Drek and David; the concept of liquidity premiums is explored to showcase the existence of illiquidity premium. Data Description: Events Time Years to Maturity Price of Bond 1 Price of Bond 2 t = 0 4 $1,013.79 $694.04 t = 1 3 1,011.02 760.57 t = 2 2 1,007.98 832.49 t = 3 1 1,002.65 912.41 t = 4 0 1,000.00 1,000.00 Using the formula below, the expected results for this event are as shown in the financial calculator screenshot. Note that this calculations considers the $1013.79 bond value. VB = Drek is an investor looking forward at buying one of the two corporate bonds sold by Drip Company, each has the same coupon payment and has the same maturity period. Bond 1 trades at $1,013.79 with no time allocated to it and 1,000 with four years’ time and maturity of 4 years Given that Bond 1 is publicly traded and Bond 2 is not, Drek refuses to pay the same price for the latter bond as it is not publicly traded. For this reason bond 2 is traded at $694.04 ad $1000.00 respectively for time allocated and maturity period as Bond 1. In this case, the difference in price and yield that the investor is willing to pay for each bond is referred as liquidity premium (Elroy, 1979). From the above results it is shown that Drek would need to invest $407.14 in order to achieve the desired future value of $1013.79 after 4 years. However, if Drek was to wait for the security to mature, he would be legible for 887.19 profit as the bond will be trading at $1901.98. David’s case Time Years to Maturity Price of Bond 1 Price of Bond 2 t = 0 20 $250,000.00 $270,000.00 t = 5 15 200,000.00 220,000.00 t = 10 10 150,000.00 170,000.00 t = 15 5 100,003.65 120,000.00 t = 20 0 50,000.00 70,000.00 VB = From the above formula and data, the following financial calculator results show the stakes of David’s investment and the anticipated variable changes. David is an investor willing to buy one of the two bonds of Mirtz Company. Each of these bonds have the same coupon rate of 10% per year and maturity period with five periods as options. Bond 1 is traded at $250,000 with zero time and $50,000 after 20 years and is traded publicly while Bond 2 is trading at $270,000 at zero time and $70,000 and is non-publicly traded. Therefore, going with the basic investor principle, David considers the publicly traded bond and incurs Bond 2 as the opportunity cost. In this case, the difference is a negative which results to a difference that cannot be considered a premium. In this case, whether the investor, David decides to buy Bond 1 or 2, his decision will not result to any liquid premium. However, if she decides to buy the non-publicly traded bond at the cost of the publicly traded bond, then David would generate an illiquid premium. In this case, David is unable to resell his Bond as most buyers would not consider a non-public bond selling at a higher price than a public one with both having the same coupon and maturity period (Elroy, 1979). From the results presented with screenshots above, David requires to invest $170,468.07 at the beginning in order to achieve $250,000. However, given that he is the buyer in this case, it means that David has to incur the charges of the investment of $79,531.93; assuming it has matured to $250,000 after the duration of four years. After, the maturity period of 4 years, David would be legible for $116,442.69. Methodology Illiquidity Adjustment Considering that all assets are illiquid but some assets being more illiquid than others, the underlying variables contributing to the valuation of an asset considers brokerage cost, bid-ask spread, price impact, and opportunity cost. Put into perspective of the three events identified in this paper, brokerage cost is the smallest component of an asset cost an investor is expected to pay. It sets the difference between bonds traded publicly and non-publicly, also defines the explicit difference between corporate bonds and treasury bonds. Bid-ask spread defines the difference between the price at which one can buy an asset from a dealer and the price one can sell the asset at the same point. Bid-ask spread relates to the illiquidity of an asset and the buyer’s remorse. Price impact involves the investor’s bid to push the price up when buying and down when selling while trading on an asset (James, 1976). Opportunity cost in security trade involves the costs involved when waiting to trade. As a patient trader, one can reduce the previous price impact and bid-ask spread, the wait has the potential to reduce profits considering that the sale of assets immediately may generate profits that may not be realized in case the waiting results to reduction of bond market price. The opportunity cost generates the reference to bid-ask spread as the latter involves the risk of inventory holding, cost of processing available orders, and the trading of a security when dealing with more informed investors. However, as a principle to generate more profits, the spread should be high enough to cover all the costs involved in the sale of the security and still yield enough profits to sustain the trader’s profession. Methodology and Analysis Drek looks forward to buying one of the two bonds traded by Drip Company and both bonds have the same maturity period and coupon value. Drek’s considerations before the purchase of either of the bonds is that he will not buy a non-publicly traded bond at the same or higher price than a publicly traded bond. With reference to the market, Drek is faced with the reality that the entity is not completely liquid and that price changes are anticipated when imbalance exists between buying and selling of orders. The price change arises due to lack of liquidity and is temporary until liquidity returns to the market. Therefore, when attempting to buy the publicly traded bond, Drek is faced with the problem of selling the bond immediately. This relates to the underlying factors of the bid-ask spread such as the cost of processing an order and the cost of dealing with an informed potential buyer. Based on the magnitude of the asset Drek aims to buy, the price impact comes into question as the information available in the market and accessible by investors influence the trading price of the security. Thus, assuming that Drek opts to buy the publicly traded securities valued at $250,000 by the dealer, then the sale of these securities will attract investors who assume that Drek possesses new information about the securities’ market. The magnitude of the bond possession and desire to sale will impact price negatively as the investors are likely to associate large securities’ sales with future market failures. On the other hand, David’s consideration to buy one of the two corporate of bonds Mirtz Company involves bid-ask spread as brokerage costs are involved. However, considering that David does not want to buy a non-publicly traded bond shows that he does not consider illiquidity discount associated with assets trading at high prices, the illiquidity increase when markets fall, and the anticipated decrease in illiquidity as the event horizon increases. Under David’s case, illiquidity is valued as an option because if one is not allowed to trade an asset, then he misses out on the opportunity if the price goes up. With reference to price impact, publicly traded securities are likely to refute the theory of perfect market because dealers will conceal information creating moral hazards. Hence, the choice to buy publicly traded bonds may restrict David from selling his securities when dealing with more informed investors. In this, assuming that David opts to buy the highly valued non-public bond, he may be provided with information on the meaning of the negative liquidity premium. With this information in hand, illiquidity discount is at David’s disposal. Additionally, relating measures of liquidity such as spreads and turnover rates with returns, David is able to estimate the discount rate for less liquid assets. This information answers the research question of whether stocks with higher illiquidity earn higher returns. Thus, the value of an illiquid asset can be computed as though it was liquid, and finally adjusted of illiquidity as discount (Debondt & Thaler, 1985). Setting high illiquidity discount rate than that of liquid assets creates the foundation for illiquidity premiums. Since illiquidity effect can be fabricated into value through the assessment of how similar illiquid companies are priced in trade transactions or the adjustment of publicly traded companies as multiples for illiquidity. Conclusion Stocks with higher illiquidity earn higher returns under the condition that all assets are considered illiquid and the margin of illiquidity differs from one asset to another. By considering the components of asset costs, theory on illiquidity discount, and empirical studies; illiquid bonds have greater yield spreads as compared to liquid bonds. Illiquidity increases as one moves from higher bond ratings towards lower ones and decrease as one moves from long to short maturities (Mitchel, & Stafford, 2000). Therefore illiquidity premiums exist as information impacts prices while investor behavior influences the valuation of publicly and non-publicly traded bonds. Additionally, publicly traded companies can be valued through the consideration of illiquidity adjustment. References Debondt, W., & Thaler, R. (1985). “Does the stock market overreact?” Journal of Finance #40: 197-226. Elroy, D. (1979). “Risk Management when share are subject to infrequent trading.” Journals of Finance #47 (2): 427-465. James, P. (1976). “Corporate forecast of earnings per share and stock price behavior: empirical tests.” J. Acc. Res #14 (2): 246-276 MacKinlay, C. (1993). “Event studies in economic and finance.” Journal of Economic Literature #35; 13-39. Mitchel, M., & Stafford, E. (2000), Managerial decisions and long-term stock price performance. Harvard Business School, #73: 278-329. Read More