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Jaroslaw Morawski Investment Decisions on Illiquid Assets

GABLER EDITION WISSENSCHAFT


Jaroslaw Morawski

Investment Decisions on Illiquid Assets


A Search Theoretical Approach to Real Estate Liquidity

With a foreword by Prof. Dr. Heinz Rehkugler

GABLER EDITION WISSENSCHAFT


Bibliographic information published by the Deutsche Nationalbibliothek The Deutsche
Nationalbibliothek lists this publication in the Deutsche Nationalbibliografie;
detailed bibliographic data are available in the Internet at http://dnb.d-nb.de.

Dissertation Universitt Freiburg, 2008

1st Edition 2008 All rights reserved Gabler | GWV Fachverlage GmbH, Wiesbaden
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Regine Zimmer, Dipl.-Designerin, Frankfurt/Main Printed on acid-free paper Printed
in Germany ISBN 978-3-8349-1004-2
To Helena
Foreword

The Portfolio Selection Model developed by Markowitz in the 1950s offers a


theoretically founded approach to combining securities into a utility-optimizing
investment portfolio, that is, a portfolio leading to the best possible trade-off
between the expected return and investment risk. However, when applied in practice,
the model often reaches its limits as soon as certain central assumptions are not
fulfilled. This holds especially for the assumption of perfect liquidity of all
assets in the portfolio, that is, the ability of selling or buying any of these
assets at any time immediately and without influencing its market price. A serious
additional source of investment risk may arise when no organized and centralized
market for a specific asset exists that would disclose the currently prevailing
price level, and when the valuations of the asset differ strongly among market
participants. Examples of such assets characterized by limited liquidity and
valuations' heterogeneity are direct real estate investments, private equity, and
many other privately traded goods. A number of rather simple extensions to the
Markowitz model allowing for listed securities with limited liquidity have been
developed to date. They are usually based on a price discount due to the lacking
ability of an immediate sale. The work of Morawski, however, goes further and
offers a complex model of market participants' behavior on illiquid markets with
heterogeneous expectations. Morawski uses his model to analyze the consequences of
imperfect liquidity for the price building on the affected markets. Furthermore, he
formulates the optimal trading strategy for buyers and sellers and derives several
approaches to measuring and managing liquidity risk on the level of individual
investments and on the portfolio level. The Theory of Search, which has received
only little attention in the theoretical finance so far, constitutes the foundation
of this innovative approach. The search model is formulated very generally, and as
such it is not restricted to any specific asset class. The assumed way of reasoning
and the exemplary practical application focus, however, on private real estate.
Illiquidity of property markets is one of the main reasons why portfolio selection
based on formal models is still not widespread there. The scope and the depth of
the analysis are unique both from the national and the international perspective.
The work comes fully up to the claim of providing ,,the first
VIII

Foreword

coherent framework for analyzing, modeling, and managing problems associated with
investing in relatively rarely traded private assets like real estate" (p. 346).
Especially the methodically and analytically challenging central parts, which
address the application of the search theory to the liquidity problem and the
connection to the classical portfolio theory, are highly innovative and seminal.
The propositions regarding the analysis of asset liquidity and the inclusion of a
liquidity criterion in portfolio optimization models will doubtlessly stimulate
further research in this field. Also, despite the high level of sophistication,
they are likely to be applied by professional investors for improving strategic
decisions. Therefore, I am certain that this book will be given due attention among
researchers and practitioners alike.

Prof. Dr. Heinz Rehkugler


Acknowledgments

This book originated during my time as a scientific assistant and a Ph.D. student
at the University of Freiburg, and has been accepted as a doctoral thesis by the
Faculty of Economics and Behavioral Sciences. Accomplishing it would not have been
possible without the aid and support of many people. At this place, I would like to
express my gratitude to all those who contributed to it directly or indirectly. My
most profound thanks go to Prof. Dr. Heinz Rehkugler, my academic teacher and
doctoral advisor. His uncountable comments and suggestions inspired many of the
ideas presented in this book and helped me to avoid numerous pitfalls. I am
grateful for his deep insights, his openness, and the freedom he granted me in the
final phase of the work. I am also indebted to Prof. Dr. Dr. h. c. Hans-Hermann
Francke, who was the second referee of the dissertation. Furthermore, I would like
to thank Prof. Dr. Rehkugler and Prof. Dr. Dr. h. c. Francke for the possibility of
absolving the Degree Program in Real Estate Appraisal at the Deutsche Immobilien
Akademie (DIA) in Freiburg. An important contribution to this work has been made by
my colleagues and fellow Ph.D. students from the Department of Banking and Finance:
Dr Isabelle Jandura, Dr Andr Schenek, Dr Ulrike Jedem, Simone Glunz, Pascal
Schnelle, Felix Schindler, and Tobias Rombach. They accompanied me during all the
years at the University helping with critical comments and discussions. To them I
owe the great atmosphere at the Department inspiring and relaxing at the same
time that made the work so much easier. I will always associate Freiburg with
their company. A special word of thanks goes to Karin Leppert, our department
secretary, for her friendship and help in formal matters. This book would not have
been possible without the support from my parents, Hanna and Franciszek. They
guided me through the first years of my education and always had faith in me after
I had taken my own way. I would also like to thank my brother Slawek, my best
friend and advisor. I could always count on him, whenever I needed help of any
kind.
X

Acknowledgments

My deepest gratitude and love, however, is reserved for my wife, Helena. Without
her patience, her enthusiasm about my work, and her encouragements in the countless
moments of doubt and frustration, I would never have been able to reach this point.
She gave me the strength and endurance to finish what I have started. Therefore, I
dedicate this book to her.

Jaroslaw Morawski
Contents

Figures ...........................................................................
............................................ XIX
Tables ............................................................................
......................................... XXIII
Abbreviations .....................................................................
..................................... XXV
Symbols ...........................................................................
....................................... XXIX
Introduction ......................................................................
............................................. 1 Why
liquidity? ........................................................................
.................................... 1 Goals of the
Analysis...........................................................................
....................... 2 Structure of the
Analysis ..........................................................................
.................. 4 Chapter 1: The Concept of
Liquidity .........................................................................
. 9 1.1. Definition of
Liquidity .........................................................................
............ 10 1.1.1. Review of Liquidity
Definitions............................................................... 10
1.1.1.1. Asset
Liquidity .........................................................................
......... 13 1.1.1.2. Market
Liquidity .........................................................................
...... 18 1.1.1.3. Corporate
Liquidity .........................................................................
.. 25 1.1.1.4. Relations between the Notions of
Liquidity ..................................... 27 1.1.2. Liquidity
Risk ..............................................................................
............. 29 1.1.2.1. Liquidity Risk of Privately Traded
Assets........................................ 29 1.1.2.2. Liquidity Risk in Public
Markets ...................................................... 32 1.1.3. A Two-
Dimensional Definition of Liquidity ........................................... 36
1.2. Sources of
Liquidity .........................................................................
................ 40
XII

Contents 1.2.1. Preliminary


Considerations ....................................................................
.. 41 1.2.2. Transaction and Opportunity
Costs .......................................................... 44 1.2.2.1.
Commissions and
Taxes ................................................................... 44
1.2.2.2. Indirect Transaction
Costs ................................................................ 48 1.2.2.3.
Opportunity
Costs .............................................................................
51 1.2.3. Market Organization and the Search for a Trading
Partner ..................... 55 1.2.3.1. Forms of Market
Organization ......................................................... 55 1.2.3.2.
Market Organization, Search, and Liquidity .................................... 59
1.2.4. Diversity of
Valuations.........................................................................
.... 64

1.3. Review of Illiquid


Assets ............................................................................
..... 73 1.3.1. Characteristics of Illiquid
Assets .............................................................. 74 1.3.2.
Real
Estate ............................................................................
.................... 76 1.3.3. Private
Equity ............................................................................
............... 81 1.3.4. Alternative
Investments .......................................................................
..... 84 1.4. Economic Relevance of
Liquidity ................................................................... 88
1.4.1. Money and Liquidity
Preference .............................................................. 88 1.4.2.
Liquidity in Investment
Decisions............................................................ 92 1.4.2.1.
Investment
Goals .............................................................................
. 92 1.4.2.2. Expected and Unexpected
Liquidation ............................................. 98 1.4.2.3. Liquidity in
the Sale Case and in the Purchase Case ...................... 100 1.4.2.4.
Individual Liquidity and Portfolio Liquidity .................................. 102
Chapter 2: Search in Illiquid
Markets .................................................................... 105
2.1. The Theory of
Search.............................................................................
........ 106
Contents

XIII

2.2. Introduction to Search


Models ....................................................................... 110
2.2.1. Search
Framework .........................................................................
......... 110 2.2.2. Search
Strategy ..........................................................................
............. 114 2.2.3. Basic Search
Model .............................................................................
... 116 2.2.4. Karlin's
Model..............................................................................
.......... 121 2.3. The Real Estate Search
Model ....................................................................... 123
2.3.1. Framework
Modifications .....................................................................
. 124 2.3.1.1. Distribution of
Offers...................................................................... 125
2.3.1.2. Continuous
Time .............................................................................
126 2.3.1.3. Opportunity Cost and
Discounting ................................................. 128 2.3.1.4. Rental
Revenues...........................................................................
... 129 2.3.1.5. Market
Uncertainty .......................................................................
.. 131 2.3.1.6. The Relative
Approach ................................................................... 135
2.3.2. Model
Design ............................................................................
............. 137 2.3.3. Limitations and Possible
Extensions ...................................................... 142 2.3.3.1.
Bounded Search
Horizon ................................................................ 143
2.3.3.2. Dynamic
Market ............................................................................
. 146 2.3.3.3. Unknown Offer Distribution and
Learning .................................... 149 2.3.3.4. Offer
Recalls ...........................................................................
........ 152 2.3.3.5. Intensity of
Search ..........................................................................
153 2.3.3.6. Listing
Price .............................................................................
....... 154 2.3.3.7. Search for the Best
Seller................................................................ 156 2.3.4.
MCS
Solution ..........................................................................
............... 158 2.3.5. Liquidity within the
Model ..................................................................... 163
2.4. Search and the Functioning of Illiquid
Markets ............................................ 166
XIV

Contents

Chapter 3: Liquidity
Measurement .......................................................................
. 171 3.1. Traditional Measures of Market
Liquidity..................................................... 172 3.1.1. Liquidity
of Public
Markets.................................................................... 173
3.1.1.1. Bid-Ask
Spread ............................................................................
... 173 3.1.1.2. Market
Depth .............................................................................
..... 177 3.1.1.3. Price
Reversal ..........................................................................
....... 179 3.1.2. Application to Real Estate
Markets ........................................................ 182 3.1.2.1.
Implicit Bid-Ask
Spread ................................................................. 182
3.1.2.2. Quick Sale
Discount .......................................................................
185 3.1.2.3. Market
Depth .............................................................................
..... 186 3.1.2.4. Market
Resiliency ........................................................................
... 189 3.2. Time- and Probability-Based
Measures ......................................................... 191 3.2.1.
Probability of Sale and Time on the
Market .......................................... 191 3.2.2. Proportional Hazard
Ratio ...................................................................... 195
3.3. Measures of Liquidity
Risk ............................................................................
197 3.3.1. Principles of Risk
Measurement ............................................................. 198
3.3.2.
Volatility ........................................................................
......................... 202 3.3.3. Asymmetric
Measures ..........................................................................
.. 209 3.3.3.1. Default
Probability .......................................................................
... 210 3.3.3.2. Semivolatility and Lower Partial
Moments .................................... 214 3.3.3.3. Value at
Risk ..............................................................................
..... 216 3.4. Alternative Measurement
Approaches........................................................... 220 3.4.1.
Liquidity Performance
Measures ........................................................... 221
Contents

XV

3.4.2. Utility-Based
Measurement ....................................................................
223 3.5. Relations between the
Measures .................................................................... 226
Chapter 4: Liquidity as a Decision
Criterion ......................................................... 233 4.1.
Investment Decisions in the Mean-Variance Framework..............................
234 4.1.1. The Efficiency
Criterion .........................................................................
234 4.1.2. Diversification and Mean-Variance Portfolio
Selection ........................ 238 4.1.3. Portfolio Selection with Risk-Free
Assets.............................................. 241 4.1.4. Limitations of the
MV-Criterion ............................................................ 242 4.2.
Strategic
Liquidation .......................................................................
............... 244 4.2.1. Literature
Review ............................................................................
....... 245 4.2.2. Efficiency of Liquidation
Strategies ....................................................... 247 4.2.3.
Liquidation Strategies for Portfolios of
Assets ...................................... 254 4.2.3.1. The Liquidity-
Diversification Effect .............................................. 254 4.2.3.2.
Covariance of
Gains........................................................................ 255
4.2.3.3. Portfolio Effect of
Liquidation ....................................................... 258 4.2.4.
Simultaneous Liquidation of Liquid and Illiquid Assets........................ 266
4.3. Optimal Liquidation and the Notion of
Liquidity .......................................... 270 4.3.1. Liquidity in Terms
of Efficient Liquidation Strategies .......................... 271 4.3.2. Liquidity
with Liquid and Illiquid Assets .............................................. 272
4.3.3. Liquidity of Assets in
Portfolios............................................................. 274 4.4.
Portfolio Selection with Illiquid
Assets ......................................................... 276 4.4.1.
Literature
Review ............................................................................
....... 277
XVI

Contents 4.4.1.1. Asset Allocation with Non-Tradable


Assets................................... 278 4.4.1.2. Models with Trade
Restrictions ...................................................... 280 4.4.1.3.
Liquidity as an Independent Decision Criterion ............................. 283
4.4.2. MPT with Illiquid
Assets........................................................................ 286
4.4.2.1. Planned Portfolio
Liquidation ......................................................... 287 4.4.2.2.
Unexpected Portfolio Liquidation ..................................................
292 4.4.3. Optimization
Algorithms ........................................................................
299 4.4.4. Sources of
Biases ............................................................................
........ 302 4.4.4.1. Effects of Search Model
Imperfections .......................................... 302 4.4.4.2. Risk
Measurement Issues................................................................
304

Chapter 5: Liquidity of German Condominium


Markets .................................... 307 5.1. Determination of Model
Parameters .............................................................. 308
5.1.1. Volatility of
Offers ............................................................................
..... 308 5.1.2. Offer Arrival
Frequency .........................................................................
311 5.1.3. Other
Parameters ........................................................................
............ 313 5.2. Condominium Liquidity
Analysis ................................................................. 314
5.2.1. Data
Material ..........................................................................
................ 315 5.2.1.1. RDM/IVD
Data ..............................................................................
. 315 5.2.1.2. GAA
Data ..............................................................................
......... 316 5.2.1.3. Determination of Model
Parameters ............................................... 319 5.2.2. Liquidity
Measurement .......................................................................
... 323 5.2.2.1. Market
Depth .............................................................................
..... 323 5.2.2.2. Market
Breadth ...........................................................................
.... 324
Contents

XVII

5.2.2.3. Time on
Market.............................................................................
.. 327 5.2.2.4. Liquidity
Risk ..............................................................................
... 331 5.2.2.5. Liquidity Risk
Reward .................................................................... 336
5.2.2.6. Two-Dimensional Liquidity
Assessment........................................ 337 5.2.2.7. Comparison of the
Measures .......................................................... 341 5.2.3.
Condominiums in Portfolio
Decisions ................................................... 347 5.2.3.1. Planned
Liquidation, Return Characteristics, and the Efficient
Frontier ..........................................................................
.................. 348 5.2.3.2. Portfolio Selection in a Multidimensional Decision
Framework with Liquidity
Criterion .................................................................. 352
5.3. Discussion of the
Results ...........................................................................
.... 357 Concluding
remarks ...........................................................................
...................... 363
Appendix ..........................................................................
.......................................... 367
References ........................................................................
.......................................... 397
Figures

Figure 1-1: Liquidity as a price-time


locus ................................................................ 16 Figure 1-
2: Ambiguousness of relative liquidity in terms of the price-time locus .... 18
Figure 1-3: Liquidity as a trade-off between execution costs, execution time, and
order
size ..............................................................................
............ 19 Figure 1-4: Temporary and permanent price effects of a seller-
initiated large sale
transaction .......................................................................
................. 23 Figure 1-5: Market breadth and market
depth ........................................................... 24 Figure 1-6:
Optimal cash
balance ...........................................................................
... 27 Figure 1-7: Optimal liquidation time without liquidity
risk ...................................... 31 Figure 1-8: Liquidity risk as the
uncertainty of the liquidation value ....................... 32 Figure 1-9:
Variations of market liquidity on NYSE and AMEX ............................. 34
Figure 1-10: Exogenous and endogenous liquidity
risk .............................................. 36 Figure 1-11: Structure of
the two-dimensional liquidity definition............................. 37 Figure 1-
12: The effect of a fixed commission on the price-time locus of
liquidation .......................................................................
........................ 46 Figure 1-13: Price-time loci for organized and non-
organized markets ...................... 63 Figure 1-14: Diversity of valuations
and the price building room .............................. 71 Figure 1-15:
Decreasing marginal utility and risk
aversion ........................................ 96 Figure 1-16: Interrelations
between the main investment goals .................................. 98 Figure 2-1:
Scheme of the search
process ............................................................... 113
XX

Figures

Figure 2-2: Determination of the optimal reservation price in the real estate
search
model .............................................................................
............ 141 Figure 2-3: Scheme of a Monte Carlo Simulation for the real estate
sale process .. 161 Figure 2-4: Monte Carlo estimation of the distribution of net
receipts from sale ... 162 Figure 2-5: Locus of expected net sale receipts and
search duration in the real estate search
model .............................................................................
.. 164 Figure 2-6: Reservation prices of buyers and sellers and the price building
in illiquid
markets ...........................................................................
.......... 169 Figure 3-1: Alternative notions of risk referred to the probability
distribution of the goal
variable ..........................................................................
.......... 201 Figure 3-2: Volatility of net sale receipts as a function of the
reservation price ..... 208 Figure 3-3: Total variability and downside risk under a
right-skewed (a) and a left-skewed (b) distribution of the goal
variable. .................................. 210 Figure 3-4: Default probability as
a function of the reservation price .................... 212 Figure 4-1: First
degree stochastic
dominance ........................................................ 236 Figure 4-2:
Mean-variance efficiency and investment choice .................................
237 Figure 4-3: Diversification effect in a two-asset
portfolio ...................................... 239 Figure 4-4: Efficient frontier
and portfolio selection............................................... 240 Figure
4-5: Portfolio selection with a risk-free interest
rate .................................... 241 Figure 4-6: Stochastic dominance of
liquidation strategies ..................................... 248 Figure 4-7:
Expected net sale receipts and receipts' volatility in the search
framework .........................................................................
.................... 251 Figure 4-8: Locus of expected net receipts and receipts'
volatility ......................... 252 Figure 4-9: Liquidity efficiency
frontier .................................................................. 253
Figures

XXI

Figure 4-10: Volatility of net receipts from liquidation of a portfolio of


identical assets as a function of the reservation price and the number of
properties ........................................................................
....................... 259 Figure 4-11: Efficiency of liquidation strategies for
portfolios consisting of multiple identical
assets ........................................................................ 260
Figure 4-12: Liquidity risk reduction and the optimality of reservation prices for
two identical assets liquidated using the same strategy ........................
261 Figure 4-13: Expected net receipts (a) and receipts' volatility (b) for two
identical assets liquidated using different reservation prices................ 262
Figure 4-14: Liquidity-efficient frontier for two identical assets liquidated using
different reservation
prices.................................................................... 263
Figure 4-15: Liquidity risk reduction for two different assets liquidated in
different
proportions .......................................................................
..... 264 Figure 4-16: Simultaneous liquidation of liquid and illiquid
assets .......................... 268 Figure 4-17: Asset liquidity in terms of
liquidity efficient frontiers ......................... 271 Figure 4-18: Asset
liquidity in terms of liquidity efficient lines ............................... 273
Figure 4-19: Portfolio decision room with a non-marketable asset according to Brito
(1978) ............................................................................
............... 279 Figure 4-20: Optimal portfolio weight of a liquid stock as a
function of the illiquid fraction for various levels of the illiquid stock's beta
in the model of Kahl et al.
(2003) ................................................................... 281
Figure 4-21: Examples of liquidity-filtered (a) and liquidity-constrained (b)
efficient portfolios according to Lo et al.
(2003) .................................. 285 Figure 4-22: Stochastic dominance
with return and liquidity goals .......................... 295 Figure 4-23:
Efficient plane and portfolio selection with a one-dimensional liquidity
goal ..............................................................................
........... 297
XXII

Figures

Figure 5-1: Expected ToM of selected German condominium markets (days)....... 331
Figure 5-2: Two-dimensional liquidity measurement of selected German condominium
markets ...........................................................................
340 Figure 5-3: Ranks of selected German condominium markets with respect to their
liquidity according to different measurement approaches............ 344 Figure 5-4:
Efficient frontier with returns corrected for liquidation effects ............ 351
Figure 5-5: Efficient frontiers with separate liquidity criteria: Implicit Spread
(a), LRR (b), and expected net receipts and receipts' volatility (c) ...... 356
Tables

Table 1-1: Definitions of liquidity on the


internet ..................................................... 11 Table 1-2:
Definitions of euro area monetary
aggregates .......................................... 15 Table 1-3: Elements of
real estate transaction costs in selected European
countries..........................................................................
.......................... 78 Table 1-4: Stages of private equity
investments ........................................................ 82 Table 1-5:
Rankings of selected investors'
goals....................................................... 93 Table 3-1: Cross-
sectional means of time series correlations between liquidity measures for
individual stocks on the NYSE. ........................................ 228 Table
5-1: Return statistics for selected German condominium markets ................ 320
Table 5-2: Parameters of the search model for selected German condominium
markets............................................................................
........................ 322 Table 5-3: Estimated number of transactions per
inhabitant in selected German condominium
markets ...........................................................................
. 324 Table 5-4: Market breadth measures for selected German condominium
markets............................................................................
........................ 326 Table 5-5: Expected ToM of condominiums in selected
German condominium markets
(days).............................................................................
............ 328 Table 5-6: Volatility of net receipts on selected German
condominium markets ... 332 Table 5-7: Liquidity risk measures for selected German
condominium markets .... 334 Table 5-8: Liquidity Risk Reward of selected German
condominium markets ...... 337 Table 5-9: Rank correlations between liquidity
measures of selected German condominium
markets ...........................................................................
. 345
XXIV

Tables

Table 5-10: Characteristics of investment returns on selected German condominium


markets with optimal liquidation at the investment
horizon ...........................................................................
......................... 350
Abbreviations

$ ADIG AMEX APT ATM BauGB c.d.f. CAPM CDAX CLA DEP DP e.g. ECB ESPR et al. EVCA f.,
ff. FN FSD FTSE FV

U.S. dollar Allgemeine Deutsche Investmentgesellschaft (mbH) America Stock


Exchange Arbitrage Pricing Theory Automating Telling Machine Baugesetzbuch
(German Construction Code) cumulative distribution function Capital Asset
Pricing Model Composite DAX (Deutscher Aktienindex) Critical Lines Algorithm
Quoted Depth Default Probability for example (lat. exempli gratia) European
Central bank Effective Spread and others (lat. et alia) European Venture
Capital Association following page, following pages footnote first degree
stochastic dominance Financial Times Stock Exchange (Index) fair value
XXVI G GAA GDP HARA HNWI i.e. IPD IPO IS IVD L-Beta, L LIAC LPM LR LRR LV LVaR M
MBO MEC MERP MPT MSC MV MVP good (quality)

Abbreviations

Gutachterausschuss fr Grundstckswerte (Appraisers' Committee) Gross Domestic


Product Hyperbolic Absolute Risk Aversion High Net Wealth Individual that is
(lat. id est) Investment Property Databank Initial Private Offering Implicit
Spread Immobilien Verband Deutschland Liquidity Beta liquid-illiquid asset
correlation Lower Partial Moment Liquidity Ratio Liquidity Risk Reward
Liquidation Value Liquidity Value at Risk medium (quality) Management Buy Out
Market Efficiency Coefficient maximal expected return portfolio Modern
Portfolio Theory Monte Carlo Simulation mean-variance, mean-volatility
(criterion) minimal-variance portfolio
Abbreviations NASDAQ NCREIF NVCA NYSE p., pp. p.d.f. PE PESPR PHR PoS PQSPR QSD
QSPR RDM RICS RV S&P SSD TEGoVA ToM TSD U.S., USA UK VaR VAR

XXVII

National Association of Securities Dealers Automated Quotations National


Council of Real Estate Fiduciaries National Venture Capital Association New
York Stock Exchange page, pages probability density function Private Equity
Proportional Effective Spread proportional hazard ratio Probability of Sale
Proportional Quoted Spread Quick Sale Discount Quoted Spread Ring Deutscher
Makler Royal Institution of Chartered Surveyors reward-to-volatility Standard
and Poors second degree stochastic dominance The European Group of Valuers
Associations Time on the Market third degree stochastic dominance United
States, United States of America United Kingdom Value at Risk Vector Auto-
Regressive (Model)
XXVIII VAT VBA VC Value Added Tax Visual Basic for Applications Venture
Capital

Abbreviations
Symbols

Due to the large amount of mathematical notations, it was not always possible to
assign each variable a different symbol. Hence, in some cases, the meaning of a
symbol depends on the context in which it is used. Roman alphabet arg max (.)
argument maximum operator A
A,

random deviation from the trend (market uncertainty parameter) continuous


random deviation from the trend random deviation from the trend in a
representative period
random deviation from the trend referring to the earlier or the later period

Add1, Add2 addends of sums (auxiliary variables) b c CFt cov(.,.) corrs D Dist e
E E(.) E(.|.) f(.) parameter of the hazard function unit observation cost
cash flow (net operating income) between t-1 and t covariance operator Spearman
correlation coefficient expected duration of the search probability
distribution from the set of possible distributions Euler's constant absolute
purchasing expense expectation operator conditional expectation operator
probability density function operator or p.d.f of the offer distribution
XXX F(.) fN(.) FN(.) fR(.) FR(.) FT(.) Gt Gi GM h h(.) H H(.) i I k ki
probability function operator or c.d.f of the offer distribution normal
probability density function operator

Symbols

cumulative normal distribution function operator or c.d.f. of the offer


distribution in period N (depending on the context) p.d.f of the relative offer
distribution c.d.f. of the relative offer distribution c.d.f. of time intervals
between offers effective sale receipts in period t absolute net receipts from
the decision on offer i minimum absolute net receipts required to avoid default
rental revenues hazard function capitalized rental revenues (auxiliary
variable) auxiliary function indexing or enumeration number of offers
indexing or enumerator rank of the ith element price impact parameter
liquidity metric

~ l l0 L Liq ln(.)

liquidity measure underlying the liquidity metric threshold level of the


liquidity metric point in the MV-room corresponding with perfect liquidity
liquidity measure (in particular, Mok's liquidity measure) logarithm operator
Symbols LVaRM market level based LVaR

XXXI

LVaRrelative market level based LVaR n N N(.) New O(p*) Old P, p p ,i E p ,i UE


pL p* p*i p*T realization of the random number of offers, number of elements,
period, or grade of the LPM (depending on the context) random number of offers or
number of shares traded at a given bid/ask (depending on the context) normal
distribution operator new offer point in the MV-room corresponding with the
reservation price p* set of past offers random price, realization of the random
price reservation price applied in the planned liquidation of asset i
reservation price applied in the unexpected liquidation of asset i listing price
absolute reservation price absolute reservation price for offer i tangential
reservation price tangential reservation array market portfolio minimum
absolute sale price required to avoid default in period i price of a marketable
and non-marketable asset optimal portfolio probability operator conditional
probability operator (random) return, realization of a random return continuous
return

p*T
PM PM,i PM, PNM POpt Pr(.) Pr(.|.) R, r rc
XXXII rd rt
rte RF RM, RNM RP ~ Rt S(.) Si SV(.) t T
~ ~ T, t

Symbols discrete return return in period t


excess return over the market (market index) in period t risk-free interest
rate returns of a marketable and non-marketable asset (random) portfolio return
corrected total return of a property investment in period i standard deviation
operator market state i semivolatility operator point in time, time interval,
the realization of a random time interval, or target of a risk function (depending
on the context) random time interval total random time or search duration,
realization of the total random time or search duration optimal duration of
search utility function operator value of further search if offer i is rejected
variance operator future minimal value of an asset current value of an asset
value of an optimally conducted search value of a search terminated within the
first t periods weight of an asset i in a portfolio confidence level

~ t U(.) Vi V(.) V* V0 Vopt Vt wi x%


Symbols X, Y, Z x 1, x 2 x(.), y(.)

XXXIII symbols denoting different assets, alternatives, scenarios etc., or


auxiliary variables parameters (especially in a utility function) auxiliary
functions

Greek alphabet
M Beta coefficient or parameter of the PHR (depending on context) relative
rent relative net receipts from sale minimum relative sale receipts required to
avoid default discounting factor capitalization factor (auxiliary variable)
risk aversion parameter relative inspection /appraisal cost frequency of offer
arrivals expected value; in particular expected value of an offer, expected net
receipts from an immediate liquidation expected value of continuous returns
volatility coefficient of offers relative purchasing expense error term in
period t relative reservation price relative reservation price in the purchase
case relative reservation price in the sale case random relative price offer,
realization of the random relative price offer minimum relative sale price
required to avoid default in period i

0 r t * B* S* , M,i
XXXIV
~

Symbols pi-constant discounting rate relative known (non-random) purchase


price
standard deviation; in particular standard deviation of offers, standard
deviation of the market uncertainty parameter standard deviation of continuous
returns covariance between asset X and asset Y deterministic linear market
trend trade volume in period t p.d.f. of the standard normal distribution,
c.d.f. of the standard normal distribution. Markov transition matrix, element of
the Markov transition matrix

A r XY

t
(.) (.) ,
Introduction

Why liquidity?
"Of the maxims of orthodox finance none, surely, is more anti-social than the
fetish of liquidity, the doctrine that it is a positive virtue on the part of
investment institutions to concentrate their resources upon the holding of `liquid'
securities. It forgets that there is no such thing as liquidity of investment for
the community as a whole" wrote Keynes in "The General Theory of Employment,
Interest and Money" (1936, p.155). And still, there is little doubt as to the
importance of liquidity for financial investments, neither among researchers nor
among investors. The "ease of liquidation", or more generally the "ease of
trading", which is the simplest (though imprecise) connotation of this term, has
been discussed by a number of leading economists, among them Marschak, Tobin, and
Hicks,1 and it is an always present subject in the daily news from financial
markets. High interest of the theoretical economy in this phenomenon is driven by
the desire to understand the differences in the economic role of different assets
and, consequently, in the differences in their valuations, which are not always
apparent and rational on the first sight. Why should a house, which has a very
direct practical use to any individual, be more difficult to sell than a piece of
paper containing only a very vague promise of future gains? And does this fact
affect the value of the former or the latter? In contrast, the interest of
investors is more practical and focuses on the consequences of liquidity for
investment activity. For this purpose, the fact of an asset being more or less
liquid than another asset can be taken as given; the key question is how to allow
for this fact in the investment strategy in order to ensure optimal results? Yet,
despite different perspectives both researchers and investors are concerned with
one and the same issue and their interests are, in fact, complementary. Hence,
although the main goal of the analysis lies in the provision of a practicable
method for coping with problems associated with investing in illiquid asset, it can
only be achieved by exploring the nature of this phenomenon in an adequate
theoretical framework. In effect, the work remains on the edge between theoretical
economic considerations and practical investment analysis.

See Marschak (1949, 1950), Tobin (1958), and Hicks (1962, 1974).
2

Introduction

Goals of the Analysis


Two main problems encountered by practitioners willing to invest in illiquid assets
are the determination of the level of liquidity and its incorporation in the
decision processes. These issues have been already discussed in the literature with
respect to publicly traded assets, mainly stocks, but they still remain unsolved
for most of the privately traded illiquid investments, especially for real estate.
For example, it is quite clear that the stocks traded on the New York Stock
Exchange are much more liquid than the building at 11 Wall Street in New York, just
as the stocks traded on the Deutsche Brse are more liquid that the building at
Neue Brsenplatz 4 in Frankfurt. It is more difficult, though probably still
feasible, to determine which of these stocks are more liquid, but it is nearly
impossible to state with the available methods which of the two mentioned buildings
in New York and Frankfurt would be easier to sell. Hence, a general method for
comparing different assets with respect to their liquidity is necessary. However,
even if the relative liquidity of two investments can be assessed, it is still
seldom possible to state how high the difference between them in this respect is.
The latter problem requires the implementation a well defined quantitative measure
that would be general enough to be applied to a class of different investments. The
development of a liquidity measure is the first step to allow for liquidity in
investment decisions. They refer, on the one hand, to the way individual
investments are conducted, and, on the other hand, to the way different investments
are combined in portfolios. The majority of existing models used for optimization
of investment decisions, including the most popular mean-variance portfolio
selection framework proposed by Markowitz (1952 and 1959), require that all
analyzed assets are perfectly liquid. This means that either the range of
application of these models is highly limited, or that the results achieved by
their application to illiquid assets yield unreliable results. The latter case can
lead to a false allocation of capital and have disastrous consequences for the
affected investors. Thus, an adequate method of assessing the consequences of
assets' imperfect liquidity for the outcome of an investment as well as for the
properties of an investment portfolio is inevitable. In order to obtain
satisfactory results, the liquidity measure on which such a method is based should
posses certain properties. On the one hand, it should take into account the effects
of investor's actions, which can potentially affect her liquidity position; on the
other hand, it should be applicable not only on the level of individual assets but
also on the portfolio level. Fur-
Goals of the Analysis

thermore, the measurement method needs to be compatible with other decision


variables and with measures of other investment goals. All in all, a coherent
decision system, of which the liquidity criterion is an integral part, becomes
necessary. The approach to the measurement and management of liquidity followed in
this work is based on the Search Theory, also known as the Theory of Optimal
Stopping. This branch of mathematical stochastics deals with a family of problems
that can be interpreted in terms of a search process. The choice of this method
arose from the theoretical analysis of the nature of liquidity and its
determinants. It its course, it turned out that the character of the search for a
trading partner during the liquidation of an investment is crucial for its
liquidity. The environment of the search and the manner of its execution are the
prime determinants of the ability to sell quickly and at a low cost. A formal
description of the corresponding process can, therefore, be used as the reference
point for analyzing liquidity. In particular, it can be utilized for the derivation
of statistical parameters of the liquidation value and liquidation time as well as
for the estimation of the uncertainty associated with the liquidation, i.e.,
liquidity risk. Due to its good extendibility, the search theoretical framework
allows for the inclusion of a number of different factors relevant in this context
and can be used for modeling a number of different situations. It is also
compatible with many of the existing decision models, in particular, with the
standard portfolio selection model. Finally, due to the possibility of deriving
easily computable closed-form solutions, the approach seems to be an excellent tool
for the application in practical investment decisions. The focus of the analysis on
the practical aspects of investment activity requires that both the measurement of
liquidity and its inclusion in portfolio decisions can be achieved on the basis of
information available to investors. The latter point turns out to be especially
problematic. In particular, smaller investors may find it difficult to access the
necessary market data, which is often scarce or proprietary in intransparent
private markets. For this reason, the book is addressed mainly to institutional
investors. Furthermore, the methods proposed here are designed mainly for the
application to direct real estate investments. Also this choice has a practical
background. On the one hand, a separate consideration of every possible private
illiquid asset would be far beyond the scope of this work. On the other hand, real
estate is by far the most relevant private illiquid asset and the lack of an
adequate method to cope with its illiquidity is most pressing. Nevertheless, the
proposed methods are very general in their nature and can
4

Introduction

be easily redefined for the application to any asset provided the required
parameters can be assessed with sufficient precision.

Structure of the Analysis


The book is structured in five Chapters. The first Chapter has an introductory
character and addresses the issue of the precise meaning of the term `liquidity'.
What was originally intended as a brief presentation of a widely accepted
definition turned out to be a complex discussion of the numerous approaches present
in the literature, which not only differ from each other but are also partially
contradictory. In effect, a single notion of liquidity that would be valid
throughout the work needed to be chosen from among the different existing ones.
However, in the course of the analysis, it became apparent that most of the
existing approaches focus on certain aspects of the problem only. In particular,
the uncertainty associated with buying or selling assets on private markets remains
mostly disregarded. Therefore, a two-dimensional definition referring to assets
rather than to markets and encompassing both the expected outcome of the
liquidation and the uncertainty about it has been formulated. In the next step, the
Chapter addresses the sources of liquidity. Also at this point researchers do not
speak with one voice. A large number of possible direct and indirect factors that
may influence liquidity of assets or markets have been thoroughly discussed and
categorized into three groups. One of the main conclusions from this analysis is
the recognition of the central role of search. This finding was formative for the
approach followed later in the analysis. The next section of the Chapter offers a
review of assets affected by the liquidity problem. The purpose of such a review is
to refer the abstractly discussed sources of liquidity to real assets and to
demonstrate how they affect investors active on the respective markets. The main
result is the reinforcement of the intuitive thesis that real estate is by far the
most important class of illiquid investments. The Chapter closes with
considerations regarding the role of liquidity in the economy. Starting with a
short discussion of the relevant economic theories, the section concentrates on the
importance of liquidity for investment decisions. In particular, its place among
investment goals is highlighted and several special aspects of this subject are
discussed. After the extensive discussion of the actual meaning of liquidity, its
sources, and its consequences, the second Chapter is devoted to the search
theoretical model, which is central for most of the later considerations. The
presentation of the theoretical background of the "Theory of Search" is offered at
the beginning. It summarizes the main
Structure of the Analysis

features of the theory and its fields of application. In the following section, the
principles of the construction of search models are outlined including two most
popular basic model forms. The subsequent section, in which a specific model of
real estate transaction process is developed and discussed, constitutes the central
part of the Chapter. After proposing several extensions to the basic search models,
which allow more accurate capturing of the specific features of property
investments, the design of the actual real estate search model is presented. It is
then thoroughly discussed with respect to its limitations as well as the
possibilities of its improvement. While most of the solutions within the model are
offered in a closed form, the analytical approach cannot always be applied. The
utilization of Monte Carlo methods, which receive special attention in a separate
subsection, can provide an approximate solution in such cases. The Chapter is
concluded with an analysis of the relations between the notion of liquidity
formulated earlier and the features of the (real estate) search theoretical model.
It demonstrates that all of the relevant aspects of the problem are captured within
the model parameters. The next, third Chapter deals with the problem of liquidity
measurement. As already stated, this is the first and probably most important of
the problems that need to be solved in order to allow for liquidity in investment
decisions. Despite the fact that a number of researchers have already approached
this challenge, still no well structured and coherent framework is available that
could be applied to a number of different asset classes. Most of the existing ones
focus only on publicly traded assets, and, thus, remain on relatively high levels
of liquidity. The presentation of these traditional measures is offered at the
beginning of the Chapter. Simultaneously, however, a method of their application to
real estate investments is proposed by reinterpreting the respective measures in
terms of the real estate search model. The second category of measures, also
present in the literature though much more seldom, is based on the assessments of
liquidation probabilities and times. It is presented in the subsequent section. A
separate section is also devoted to measures of liquidity risk understood mainly as
the uncertainty of liquidation, which has been identified as an independent
dimension of liquidity in Chapter 1. These measures are largely a novel development
and result from the combination of popular methods of investment risk measurement
with the real estate search model. Finally, the last group of measures is discussed
under the caption "alternative approaches". Their common feature is the inclusion
of both di-
6

Introduction

mensions of liquidity "marketability" and "liquidity risk" within one figure.


The Chapter closes with the analysis of the relations between the discussed
measures. The fourth Chapter concentrates on the actual goal of the work the
specification of methods for including liquidity as a criterion in investment
decisions. Like in the earlier parts of the thesis, also here institutional real
estate investors are addressed in the first line. The central idea is to combine
the real estate search model with the meanvariance decision model. This way, the
search theoretical approach developed in Chapter 2 can be implemented in the
widespread and well researched investment decision framework. For the sake of a
structured presentation, the principles of decision making (portfolio selection) in
the mean-variance room are presented first. The brief introduction of the main
features of the Modern Portfolio Theory (MPT) should, on the one hand, provide the
theoretical background for applying analogous methodology to the liquidation
problem and, on the other hand, ensure a coherent terminology in the following
parts of the Chapter. The next section deals with strategic liquidation of assets.
In particular, a method for determining the optimal liquidation strategy for
portfolios containing illiquid asses (real estate) is proposed. Pure real estate
portfolios and portfolios containing both liquid and illiquid investments are
considered separately. The conclusions from this section have consequences for the
understanding of the term `liquidity'. It turns out that the level of liquidity may
differ depending on whether an investment is viewed on a stand-alone basis or
whether it is viewed in the portfolio context. These issues are discussed in the
subsequent section. In the final section of the Chapter, an extension to the
standard portfolio selection model is proposed in which liquidity is allowed for as
a separate decision criterion. After the presentation of solutions for two
different liquidation cases and the discussion of optimization algorithms in the
extended model, possible sources of biases and their effects are discussed. The
main goal of the final Chapter of the book is to demonstrate how the techniques
discussed in the preceding chapters can be applied in practice. Condominium
investments in selected German urban areas have been chosen for this purpose. The
analysis of their liquidity gives also the opportunity to discuss problems arising
in the implementation of the search theoretical approach. Determination of the
values of model parameters constitutes the main difficulty. Although their
interpretations within the search model are relatively straightforward, some of
them cannot be observed directly. The necessity to fall back on measurable proxies
results in further sources of biases.
Structure of the Analysis

Having discussed the related problems theoretically, the Chapter turns to the
empirical analysis on the basis of a unique data set for condominiums provided by
Appraisers' Committees (Gutachterausschsse fr Grundstckswerte) in five German
cities. After the demonstration of various liquidity measurement techniques as well
as optimization methods for portfolios containing investments in condominium
markets, the achieved results are compares and discussed. This step closes the
Chapter. The concluding remarks offered at the end of the book summarize the main
findings, point out their contributions to research on liquidity, and offer an
outlook for further studies in this field.
Chapter 1 The Concept of Liquidity

The main goal of the initial chapter of this work is to formulate the concept of
liquidity and, thus, to prepare the foundation for the entire following analysis.
Unambiguous definitions of the key terms are not only necessary for delimiting the
discussed problems from other related issues in finance but also essential for
ensuring the consistency of the measurement and management approaches proposed
later. The review of the literature reveals a substantial disagreement among
researchers concerning the nature of liquidity, its sources, and its consequences
for investors. The use of liquidity related terms is chaotic and definitions are
partially self-contradictory. This Chapter is an attempt to provide a structured
concept, though a number of issues are still left open. In the first place,
however, it should be viewed as the basis for the analysis in the following parts
of the book. The term "liquidity" is widely used in the literature, though its
understanding varies significantly. The goal of the first section of the Chapter
is, thus, to provide an unambiguous definition, which could be referred to
throughout the analysis. Firstly, existing notions of liquidity are reviewed and
classified into two main approaches: one focusing on the characteristics of assets
(asset liquidity) and the other one regarding the subject from the market
perspective (market liquidity). In the second step, the concept of liquidity risk
is introduced and integrated into these approaches; a two-dimensional notion of
liquidity results. The second section of the Chapter is devoted to the analysis of
sources of liquidity and liquidity risk. In particular, the main characteristics of
investments and investment environments, which may have a significant impact on
different aspects of liquidity, are discussed. The following, third section adds a
practical dimension to the discussion. A review of assets with respect to which
liquidity problems are especially severe is offered and their characteristics are
analyzed. The identification of illiquid assets is also necessary to determine the
scope of application of the methods developed later. Finally, the fourth section
deals with the economic relevance of liquidity. Its role in the economy is
discussed concentrating especially on individual investment decisions.
10

Chapter 1: The Concept of Liquidity

1.1.

Definition of Liquidity

Paraphrasing the statement of the US Supreme Court on pornography some researchers


state that "liquidity, like pornography, is easily recognized but not so easily
defined"2. Indeed, both the investment theory and the practice seem to have
substantial difficulties in formulating a clear definition. The term is mostly used
without further explanations under the assumption any reader would know what is
meant. In many cases, especially in the day-to-day trading, it is not really
necessary to theorize extensively on the meaning of liquidity. Most investors can
intuitively qualify the main markets or asset types as liquid or illiquid and
recognize the related effects. However, the lack of a formal definition causes
serious problems when developing formal approaches considering liquidity as an
investment criterion. Therefore, this task has to be dealt with at the very
beginning of the first Chapter. 1.1.1. Review of Liquidity Definitions

Doubtlessly the most frequently cited definition of liquidity, dating back to 1930,
is the one provided by Keynes in his "Treatise on money". Referring to bills and
call loans of a bank he describes them as "...more `liquid' than investments, i.e.,
more certainly realizable at short notice without loss..."3. A lot of research
referred to this definition since then,4 but also numerous new approaches have
arisen. Today, searching the internet for the term "liquidity" yields a huge number
of hits in various online lexicons on finance. A selection is presented in the
Table 1-1.

2 3 4

See, e.g., O'Hara (1997), p. 215, David Porter in Caginalp et al. (2002), p. 40, or
Roll (2005), p. 8. Keynes (1930), p. 67. E.g., Hicks (1962), Miller (1965), or
Lippman/McCall (1986) offer extensive discussions on the precise meaning of the
Keynes' liquidity definition.
1.1 Definition of Liquidity
Table 1-1: Definitions of liquidity on the internet5

11

The ease with which an asset can be turned into cash.


http://www.morganstanley.com/im/glossary/ ...ability to buy or sell an asset
quickly and in large volume without substantially affecting the asset's price.
Shares in large blue-chip stocks like General Motors or General Electric are
liquid, because they are actively traded and therefore the stock price will not be
dramatically moved by a few buy or sell orders. ...
http://www.pbucc.org/pension/tools/glossary.php The ability of the market in a
particular security to absorb a reasonable amount of buying or selling at
reasonable price changes. Liquidity is one of the most important characteristics of
a good market. http://www.4insurance.com/annuity/glossary.asp The proportion of
cash or cash equivalents in a company's assets. Sometimes used as a measure of the
near term financial health of a company. Also a measure of the volume of shares
being traded, which may affect the ability of buyers or sellers to build/unwind
large holdings without a substantial impact on the price. http://www.scottish-
newcastle.com/sn/investor/services/glossary/ The ease and speed with which an
investment can be converted into cash. http://www.tiaa-
cref.org/pubs/html/financial_terms/kl.html The ability to buy or sell an asset
quickly or the ability to convert to cash quickly
http://www.reliancemutual.com/mportal/VirtualPageView.jsp The ability to have ready
access to invested money. Mutual funds are liquid because their shares can be
redeemed for current value (which may be more or less than the original cost) on
any business day. http://www.mtbfunds.com/education/glossary.php Refers to the ease
with which an investment may be converted to cash at a reasonable price.
http://www.globefund.com/centre/Glossary_IFIC.html The ability of a market to
accept large transactions. http://www.fx-forex-trading.com/glossary.htm A measure
of the ease with which an asset can be converted to cash without the loss of
principal. http://www.reidepot.com/Glossary/l.html The ability of an asset to be
converted into cash quickly and without discount.
http://www.smartfunds.ie/glossary.html The ease with which something can be bought
or sold (converted to cash) in the marketplace. A large number of buyers and
sellers and a high volume of trading activity are important components of
liquidity. Depth, or the ability of the market to absorb either a large buy or a
large sell order without a significant price change in a security, is also crucial
to the liquidity of the market. ...
http://www.sia.com/capitol_hill/html/glossary.html How quickly and easily an asset
can be converted into cash. http://print.smallbusiness.findlaw.com/starting-
business/starting-business-moretopics/starting-business-buying-glossary.html

Selected results generated by ,,Google" (http://www.google.com) on 20th January


2006 after entering the search term ,,define: liquidity". Links may be subject to
change.
12

Chapter 1: The Concept of Liquidity


Refers to an investor's ability to sell an investment as a means of payment or
easily convert it to cash without risk of loss of nominal value.
http://www.fhwa.dot.gov/innovativefinance/appf_04.htm The ability of an individual
or business to quickly convert assets into cash without incurring a considerable
loss. http://www.partnersmortgage.com/glossL.htm Measure of a firm's ability to
quickly convert assets into cash. A firm is said to be liquid if its liquid assets
exceed short-term liabilities.
http://www.mastercardbusiness.com/mcbizdocs/smallbiz/finguide/glossary.html This
refers to how easily securities can be bought or sold in the market. A security is
liquid when there are enough units outstanding to allow large transactions without
a substantial change in price. Liquidity is one of the most important
characteristics of a good market. Liquidity also refers to how easily investors can
convert their securities into cash and refers to a corporation's cash position,
i.e. how much the value of current assets exceeds current liabilities.
http://www.geoshares.com/glossary.htm The ability of the market for a security to
absorb a reasonable amount of buying or selling without major price changes.
http://www.msc.gov.mb.ca/education/glossary.html The ability to convert assets into
cash (or cash equivalent) without significant loss. If a business has good
liquidity they will be able to meet their maturing obligations promptly, earn trade
discounts, benefit from a good credit rating, etc.
http://www.americancashflow.com/bcnucapital/Glossary.html A measure of the ability
of an individual, business, or institution to convert assets to cash without
significant loss at a particular point in time.
http://www.ncbuy.com/credit/glossary.html The quality of being readily convertible
to cash. http://www.amark.com/faq/glossary.asp The ability of a business to
generate cash to meet its financial obligations as they become due.
http://www.extension.iastate.edu/agdm/wholefarm/html/c3-05.html Depth of market to
absorb buy and sell interest of even large orders at prices appropriate to supply
and demand. The market must also adapt quickly to new information and incorporate
that information into the stock's price. Liquidity is one of the most important
characteristics of a good market. http://www.candlestrength.com/stock-trading-
glossary.htm The ability of an insurer to convert its assets into cash to pay
claims if necessary. http://www.insweb.com/learningcenter/glossary/general-l.htm
Refers to the ability to buy and sell with little or no impact on price stability.
The number of players in a market/security has a direct impact on this ability. The
FX market is the most liquid market in the world.
http://fxtrade.oanda.com/help/glossary/glossaryL_R.html being in cash or easily
convertible to cash; debt paying ability http://wordnet.princeton.edu/perl/webwn
Market liquidity is a business or economics term that refers to the ability to
quickly buy or sell a particular item without causing a significant movement in the
price. The term is usually shortened to liquidity.
http://en.wikipedia.org/wiki/Liquidity


1.1 Definition of Liquidity

13

A similarly diverse picture arises from the review of liquidity definitions in


textbooks on finance and financial management. E.g., Reilly/Brown (1997, p. 106-
107) describe it as the "ability to buy and sell an asset quickly and at a known
price"; according to Bodie/Merton (1998, p. 35), it is "the relative ease and speed
with which an asset can be converted into cash", and according to Arnold (2005. p.
G18), liquidity is "the degree to which an asset can be sold quickly and easily
without loss in value"; Schwartz/Francioni (2004, p. 60) call an asset liquid if it
is "readily convertible into cash" and Brealey et al. (2006, p. 1000) if it is
"easily and cheaply turned into cash", and for Begg et al. (2003, p. 315) liquidity
is the "cheapness, speed, and certainty, with which asset values can be converted
back into money". Slightly different formulation is used by Sharpe/Alexander (1990,
p. 804), who see it as "the ability of investors to convert securities into cash at
a price similar to the price of the previous trade in the security, assuming no
significant new information has arrived since the previous trade", or by Harris
(2003, p. 394), who defines liquidity as "the ability to trade large sizes quickly,
at low cost, when you want to trade". On the other hand Brealey et al. (2006, p.
789) describe a company that can "easily lay its hands on cash" as liquid; and for
Moyer et al. (1998, p. 609) it is "the ability of a firm to meet its cash
obligations as they come". This short review of various approaches reinforces the
earlier formulated statement that there is no general agreement on the precise
meaning of the term "liquidity" in the financial community. Nevertheless, there is
some regularity in its understanding. It seems possible to classify the most
frequent definitions depending on the object to which they refer: assets, markets,
and companies.6 These three approaches are discussed more closely in the following
subsections.

1.1.1.1. Asset Liquidity


Liquidity understood as a characteristic of assets reflects probably the most
popular approach to this subject dating back to Keynes.7 In this case, it is
understood as the ease of converting an asset into cash. In other words, the easier
an asset is sold the more liquid it is. Consequently, cash itself is assumed to be
most liquid and other assets can be classified in reference to it as more or less
"cash-like".
6 7

See also http://www.riskglossary.com/articles/liquidity.htm (viewed on 15.01.2006).


See FN 3.
14

Chapter 1: The Concept of Liquidity

Though intuitively simple, this definition contains several disputable elements.


First, the definition of "cash" needs to be provided.8 The simplest one refers only
to coins and banknotes issued by the central bank. However, it seems obvious that
this approach is far too narrow a number of alternative means of payment are in
use in most countries. Electronic money on banking accounts, checks, or bills of
exchange are practically just as liquid as cash, since they can either be converted
into banknotes immediately at no cost, or are directly accepted as cash
substitutes. Thus, it seems reasonable to extend the meaning of cash to other media
of exchange circulating in the economy. Also further positions, like saving
deposits or treasury bonds, can be liquidated very quickly at (almost) their face
value, so that they are practical equivalents to cash in most cases.9 The broad
category of all that can be considered as money is usually denoted as liquidity
supply. For the purpose of its measurement, which is inevitable for practical
monetary policy, different money aggregates are defined by central bankers.10 E.g.,
according to the European Central Bank (ECB), the narrowest M1aggregate of money
supply contains apart from currency in circulation also overnight deposits; M2
encompasses additionally deposits with maturity of up to 2 years as well as those
accessible at 3 months notice; finally, repurchase agreements, money market fund
units, and debt securities with the maturity of up to 2 years are also included in
M3 (see Table 1-2). Aggregates used in other regions are generally similar.11

8 9

10 11

See also the discussion of the functions of money in section 1.4.1. On various
forms of money see Mishkin (2006), pp. 48 ff., Howells/Bain (2005), pp. 228 ff., or
practically any text-book on banking and finance. On the measurement of money
supply see, e.g., Mishkin (2006), pp. 51 ff. For an international overview of money
aggregates' definitions see Howells/Bain (2005), pp. 231 ff.
1.1 Definition of Liquidity
Table 1-2: Definitions of euro area monetary aggregates12 Liabilities Currency in
circulation Overnight deposits Deposits with an agreed maturity of up to 2 years
Deposits redeemable at notice of up to 3 months Repurchase agreements Money market
fund shares/units Debt securities issued with a maturity of up to 2 years M1 X X M2
X X X X M3 X X X X X X X

15

Which of these categories is to be considered as cash in the sense of the liquidity


definition is unclear. Currency issued by the central bank definitely does account
as such. In fact, the M1 aggregate (or respective equivalents) should be
appropriate in most cases. However, specific contexts need to be considered, as
some types of money may lose their "cash-like" character under certain
circumstances. E.g., deposits with commercial banks may prove highly illiquid in
times of banking crises. Also the personal situation of the investor may play a
role. While an overnight money market deposit might be as good as an on-sight
deposit for some individuals, one day delay in the access to the funds is already a
potential liquidity bottleneck for others. This subjectivity in the perception of
cash leads to the respective subjectivity in the relative assessment of liquidity.
Assets may be viewed as more or less liquid just because they can be converted into
different sorts of money. E.g., selling an asset against a banknote and selling it
against a cash check may make no difference to some investors but a substantial
difference to others. Obviously, investors' individual positions, especially the
level of time pressure, play a great role at this point. The term "easily
convertible" causes even more problems than the term "cash". In the most intuitive
meaning, the conversion should require no or only little intellectual and
organizational effort. In this sense, treasury bonds are liquid because selling
them only requires a telephone call to the stock broker, and a Picasso painting is
illiquid because selling it requires the organization of an auction or a tedious
search for an interested buyer. However, many of the definitions in the literature
additionally remark that the conversion into cash should be quick and without loss.
In fact, if the selling effort, independent of its actual nature, is understood as
a time and money consuming process,
12

See ECB (2004), p. 37.


16

Chapter 1: The Concept of Liquidity

the ease of sale can be viewed in terms of a combination of the selling duration
and the selling cost. The above considerations lead to the notion of liquidity as a
function of time and the realized sale value. This duality has been recognized
already by Hicks (1962) and Miller (1965) as an interpretation of Keynes'
definition cited earlier.13 According to it, an illiquid asset is one that can be
sold promptly only at a discount; on the other hand, a longer liquidation period
has to be accepted if the fair value is to be preserved. This approach can be
presented graphically as a locus of time and liquidation value (see Figure 1-1). A
perfectly liquid asset (X) can be sold at its current fair value immediately.
Extending the duration of the liquidation process has no effect on the realized
price; the price-time locus is therefore a straight line in this case. On the other
hand, less liquid assets (Y and Z) can be sold immediately only at a discount
converging closer to the fair value is possible if longer liquidation periods are
accepted. Thus, the liquidation price is an increasing function of the liquidation
time.

Price

Fair Value X Y Z

Time Figure 1-1: Liquidity as a price-time locus

The "price-time approach" reveals the multi-faceted character of liquidity. It


cannot be described with reference to only one variable without a loss of certain
crucial properties. Ignoring the price aspect would indicate the impossibility of a
quick liquidation. This is, however, not true with respect to most assets. Almost
everything can be sold quickly if the price is reduced far enough to convince an
individual who was actually
13

See also Hasbrouck (1991a), p. 8, or Dubil (2003b), p. 2.


1.1 Definition of Liquidity

17

not intending to buy at the given time to change her mind. Note that in some
extreme cases this may result in negative prices. They may occur, when the asset in
question is very special and, in fact, worthless to most market participants; they
would only be ready to own it if they are adequately compensated. One could
paraphrase this aspect of liquidity with the words "there are no unsalable assets,
there are only improper prices". On the other hand, ignoring the time aspect would
make liquidity undistinguishable from pure discounts on the nominal value. There
would be no practical difference between liquidity and price reducing effects such
as commissions or turnover taxes. Although the latter can affect liquidity (see
section 1.2.2.1), they only constitute one aspect of the problem. In particular,
they are definite and do not depend on the liquidation time, while the nature of
liquidity lies in the possibility of avoiding discounts by prolonging the
liquidation process. The price-time definition has also important consequences for
the comparability of assets with respect to liquidity. In the sense of Figure 1-1,
the asset Y can be unambiguously identified as more liquid than Z because the
respective time-price locus of the former one lies completely above the latter one.
In other words, for any liquidation time a (relatively) higher price can achieved
for Y than for Z or the same price can always be achieved quicker for Y than for Z.
However, it is theoretically possible that the loci of two assets intercross each
other so that none lies always above the other this case is depicted in Figure 1-
2 for assets Y' and Z'. While a quick increase in the price of the former one is
possible up to a certain level, it takes very long to achieve further improvements
above this level; on the other hand the asset Z' allows a more steady improvement
of the liquidation price with longer liquidation times. In effect, there is no
possibility to state which of the two assets is objectively more liquid. The
relative liquidity can only be assessed subjectively on the basis of investors'
preferences. Those attaching more importance to time would probably consider Y' to
be more liquid and those to whom the price is more important would judge Z' as more
liquid. By expressing investor's time preference with a discount rate, it is
possible to redefine the loci in terms of present rather than nominal values. It
may then turn out that such modified liquidation present value-time locus is higher
for Y' or Z' in its full length. But even then a group of investors may exist to
whom the assets' relative liquidity remains ambiguous. Thus, by assuming the price-
time approach to asset liquidity, one has to accept the eventuality that a clear
cut-off between more and less liquid investments is not possible.
18

Chapter 1: The Concept of Liquidity

Price

Y'

Z'

Time Figure 1-2: Ambiguousness of relative liquidity in terms of the price-time


locus

Note that the definition of liquidity formulated in this section can and should be
understood very broadly. The discount to the fair value is defined as encompassing
all sorts of "efforts" including, e.g., the cost of employing professional brokers,
appraisal cost etc. In the extreme case, even the (abstract) cost of learning how
to operate an ATM can be interpreted as a liquidity discount associated with
converting money on a banking account into cash. On the other hand, the time aspect
of liquidity encompasses the entire duration of the selling process from the moment
of the decision to sell to the moment of cash receipt. This includes the time
necessary to find a trading partner, to deal with all formalities, and to realize
the payment check; also the time required for walking to the nearest ATM falls
under this category. Due to its generality and practical convenience, this
definition of liquidity is the starting point for most of the following
considerations.

1.1.1.2. Market Liquidity


The second possible meaning of liquidity refers to markets. According to it, a
liquid market is one on which trading is possible at any time, and, independent of
the transaction size, it does not induce fundamentally unjustified price changes.
In this sense, the market for U.S. Treasury Bonds is liquid since practically any
amount of the bonds can be absorbed at the current price, and it is most unlikely
that the market would react to such a large transaction. On the other hand, selling
a large number of flats in one resi-
1.1 Definition of Liquidity

19

dential area at one time is usually extremely difficult, and it would certainly
affect the level of house prices on the local market. Despite its brevity, the
above definition encompasses a number of dimensions. The main of them are time (how
long does it take to liquidate a position?), quantity (how large positions can be
liquidated?), and price or liquidation cost (how high discount on the fair value
has to be accepted at liquidation).14 Depicting liquidity as a trade-off between
the execution time, order size, and execution cost yields a three-dimensional plane
presented in Figure 1-3.

Figure 1-3: Liquidity as a trade-off between execution costs, execution time, and
order size15

The time, size, and cost dimensions refer to single transactions. In order to speak
of market liquidity, one needs to translate them into properties of markets.
Literature on liquidity of organized financial markets usually identifies its three
main components:

14 15

See Moorthy (2003), p. 29, Lo et al. (2003), p. 56, or Hodrick/Moulton (2007), p.


1. See Moorthy (2003), p. 30.
20

Chapter 1: The Concept of Liquidity

breadth (also referred to as width or tightness), depth, and resiliency.16 They


correspond with the characteristics of markets which determine the possibilities of
closing any transaction at any time without moving the prices, and also reflect
three different possible sources of illiquidity. Although widely used, these terms
are often understood in slightly different ways. Garbade (1982, p. 420) defines
market breadth as the situation in which "there exist orders, either actual or
easily uncovered, both above and below the price at which a security is actually
trading"17; Kyle (1985, p. 1316) defines tightness as "the cost of turning around a
position over a short period of time"; and to Fernandez (1999, p. 10) breadth is
"the distance from the mid-market prices to the transactions that actually occur".
Mostly, however, breadth is associated with the bid-ask spread. A more general
definition is assumed in this work; according to it, breadth is understood as the
(abstract) distance between the sellers and the buyers with respect to the
valuation of the asset traded on the market. Larger distances result in larger
discounts to the (objective or subjective) fair value that sellers need to accept
in order to sell the asset quickly or the in larger premiums that buyers need to
pay in order to purchase the asset quickly. Thus, larger distances result in less
liquid markers since it is more difficult for traders to find acceptable prices
without deferring substantially from their own valuations. The form of
manifestation of market breadth depends on the form of market organization.18 In
dealer type markets, in which dealers or market makers are present, the bidask
spread is the natural measure of breath.19 This is possible because market makers
are obliged to trade any asset with any investor at any time provided that she
accepts the prices quoted by them. The price at which the market maker is ready to
buy (bid) and the price at which he is ready to sell (ask) determine the price
levels for both sides of the market. In the absence of market makers or dealers,
breadth is more difficult to observe. However, it is straightforward that finding a
trading partner becomes more difficult when valuations of sellers and buyers go
apart. Low breadth in auction mar-

16

17

18 19

The identification of the three liquidity components was probably introduced by


Garbade (1982), p. 419-422, for the first time, but it is also used by a number of
other authors including Kyle (1985), p. 1316, Bernstein (1987), p. 55-56, or
Schwartz/Francioni (2004), p. 60-61. Note that the terms "breadth" and "depth" are
switched in Garbade (1982); thus Garbade's "depth" corresponds widely with what in
this section is referred to as "breadth" and vice versa. See section 1.2.3.1 for an
overview of the forms of public market organization. The bid-ask spread is
discussed in more detail in section 3.1.1.1.
1.1 Definition of Liquidity

21

kets with market and limit orders would mean that buy orders are placed at low
limits while sell orders are placed at high limits, leaving little room for price
setting. In the extreme case, no single market price may exist at which any trade
would be possible. Although the concept of market breadth is usually associated
with public markets, the same principle should also apply to private markets
without organized trade structures. Wherever the prices demanded by sellers are far
above the prices offered by buyers the market can be described as "broad". Under
such circumstances only relatively few trades can be executed, and an investor
determined to sell or to buy will be able to do so only if she accepts less
favorable conditions. Hence, larger gaps between buyers and sellers (i.e., larger
market breadth) indicate lower liquidity.20 The concept of market depth is based on
the number of market participants ready to trade rather than on their readiness to
pay. Yet, also here the definitions found in the literature go slightly apart. Most
researchers understand depth either as the availability of counteroffers, or as the
quantities quoted by market makers, or as the maximum trading volume not affecting
the prices.21 In either case, the size of the market (however defined) plays the
central role. The reference to market liquidity is relatively straightforward
finding a trading partner offering an acceptable price should be relatively easier
in markets on which numerous traders are active simultaneously than on markets with
only few active traders. E.g., it is definitely easier to sell shares on the NYSE
with ca. 6 million transactions a day, than on the Warsaw Stock Exchange with only
ca. 40 thousand transactions a day;22 but selling shares on either of these stock
markets is still incomparably easier than selling apartments on a real estate
market in a small town with only few transactions a year. Hence, large markets are
considered to be deeper and as such more liquid than small ones. The size of the
market, though undoubtedly highly important for liquidity, is, as noted by Persaud
(2002), not per se sufficient for market liquidity. It has to be accompanied by
sufficient diversity of traders to unfold its effect. Persaud illustrates it by
comparing two idealized markets: one with only two and the other one with thousands
of traders.
20

21 22

An analogical approach is followed by Garbade (1982, p. 420-422). He defines a


broad market as one, in which traders differ with respect to their valuations and
place (limit) orders at different values. However, Garbade's conclusion is contrary
to the one formulated here he considers a broad market to be generally more
liquid. See Kyle (1985), p. 1316, Fernandez (1999), p. 9, or Harris (2003), p. 398.
See http://www.nyse.com and http://www.gpw.com.pl (estimated figures as of January
2006).
22

Chapter 1: The Concept of Liquidity

He assumes in his example that whenever one of the traders on the first market
wants to sell, the other one wants to buy and vice versa. In contrast, whenever one
of traders on the second market wants to sell (buy), all the other ones want to
sell (buy) as well. In effect, despite the much smaller size, the first market is
perfectly liquid and the second one, though much bigger, is perfectly illiquid.23
Hence, only if both sides of the market are balanced, more depth leads to higher
liquidity. In normal times, this balance is ensured by the activity of noise
traders. While insider or information traders act upon their superior knowledge
about the true value of the asset, noise traders trade for other reasons, which
arise from their personal situations or specific expectations about the future.24.
While the former ones become active only if the current market price drifts away
from the fair valuation of the asset, the latter ones buy and sell (to some extent)
independently of the market price level. As noted by Black (1986), a market with
full information and without noise, no matter how big, would be extremely illiquid.
If prices fell below the fair value, everybody would like to buy; if prices rose
above the fair value, everybody would like to sell; and with prices at the fair
level, nobody would have an incentive to trade. The existence of investors who
trade for exogenous reasons provides the necessary diversity and consequently the
depth of the market. Thus, noise trading is essential for market liquidity. The
practical relevance of market depth lies not only in the possibility of finding a
buyer or a seller for a single unit of an asset but also in the ease of trading
larger quantities of assets. An investor willing to accomplish an unusually large
transaction, e.g., a sale of a large stock holding, is forced to fall back on
buyers offering less favorable prices. On an auction market like a stock exchange
it means that not only orders at the current market price but also orders below it
need to be utilized. In consequence, the realized price per share deteriorates and
the after-trade market price decreases. This effect is denoted as the market impact
of trading.25 For any market a certain transac23

24

25

Note that the diversity in the sense of Persaud (2002) is similar but not identical
with market breadth. The latter is about the divergence of valuations among
investors while the former one is about their willingness to buy or to sell at
these valuations. The differentiation of the information and noise traders was
probably made by Black (1986) for the first time. It constitutes an important part
of many theories of market microstructure and is present in numerous models; see
Copeland/Galai (1983), Kyle (1985), or Glosten/Milgrom (1985). See also O'Hara
(1997), Chapter 3, for a review. The impact of large transactions has been
researched mainly in the context of security block transactions, i.e., transactions
of larger blocks of shares. See Dann et al. (1977), Holthausen et al. (1987), or
Keim/Madhavan (1996). See also O'Hara (1997), pp. 233 ff., for a review.
1.1 Definition of Liquidity

23

tion size exists above which an inferior price has to be accepted and the impact of
trading becomes relevant. However, it is reached quicker on smaller markets than on
larger ones. With sufficient depth it should be possible to meet on enough demand
(supply) to sell (buy) even a substantial amount of an asset at the usual market
price; without it, the trade will cause a change in the market price level, which
does not necessarily need to be associated with a change in the asset's
fundamentals. In this context, it is useful to differentiate between the temporary
and the permanent impact (see Figure 1-4). The first one disappears after a certain
period of time when new traders arrive on the market, while the second one does not
it is the result of a change in the general opinion of market participants about
the value of an asset, which has been induced by the trade. The delimitation of
both effects depends, of course, on the applied time horizon.

Price

P0

P2

Permanent effect Temporary effect

P1

t0

t1

t2

Time

Figure 1-4: Temporary and permanent price effects of a seller-initiated large sale
transaction26

Note that the consequences of market breadth and market depth for an individual
investor are similar. Both aspects of liquidity refer to the discount on the fair
value that must be beard in order to accomplish a transaction within a reasonable
period of time. However, while breadth stands for the cost of trading in typical
situations, depth determines how these costs depend on the size of the deal (see
Figure 1-5). In effect, the former one is relevant for investors trading frequently
and the latter one for investors trading large quantities. Basing on this
distinction, Bangia et al. (1999, pp. 3-5) intro26

See Holthausen et al. (1987), p. 241, or Dubil (2002), p. 68.


24

Chapter 1: The Concept of Liquidity

duced the terms of exogenous and endogenous liquidity. The former one refers to the
market normal state and is determined by technical, political, or economic factors.
The latter one refers to the effects of trading on the market price level. Thus, up
to a certain order size only exogenous liquidity is experienced; the endogenous
liquidity occurs above the volume at which the spread between the selling and the
buying price starts to widen it corresponds roughly with the crook of the price-
volume curves depicted in Figure 1-5.

Volume

Breadth

Depth

Selling price

Purchasing price

Figure 1-5: Market breadth and market depth27

With the market impact of trading a dynamic dimension of liquidity has been
introduced. However, from the market perspective even more important than the sole
price change is the speed at which the price level recovers after a large
transaction or some other event causing a temporary order imbalance. It is denoted
as market resiliency.28 Since fundamentally unjustified price changes are not
accompanied by any changes of factors which determine assets' values, they should
be outbalanced by additional orders from traders willing to take advantage of the
temporary over- or underpricing. How quickly such counter reactions occur is
central for the resiliency of markets. One would suspect that the flow of new
orders should be sufficient to restore the market equilibrium within a short period
of time in liquid markets, but it may take much longer in small and illiquid
markets. In Figure 1-4, resiliency can be associated with the length of the time
gap between t1 and t2, i.e., with the duration of the temporary price
27 28

See Buhl (2004), p.12, or Schmidt-von Rhein (1996), p. 148. See Garbade (1982), p.
422, Kyle (1985), p. 1316, or Schwartz (2004), p. 61.
1.1 Definition of Liquidity

25

impact of trading. Note, however, that resiliency refers to the speed of reactions
to any unjustified price changes and not only to those induces by large
transactions. At first sight, resiliency seems to be closely related to market
depth. Deeper markets should not only be less prone to market impacts but also
react more quickly to trading activity. However, this mechanism works only if
investors can learn about the unjustified price change and its backgrounds (e.g., a
large transaction) quickly enough.29 It requires that channels exist through which
such information can be forwarded to interested market participants. While it is
usually unproblematic in organized markets in which prices and trading volumes are
quoted publicly, it might be a serious problem in non-organized markets. Without a
central source of information some investors who would be interested in trading at
the (temporarily) favorable prices will not be able to do so simply because they
will not learn about the order imbalance on time. In effect, the traders on the
"underrepresented" side of the market are forced to either postpone their
transactions or to accept unfair prices. Thus, what distinguishes resiliency from
other aspects of liquidity is the role of the flow of information among market
participants.

1.1.1.3. Corporate Liquidity


The third group of liquidity definitions refers to the ability of companies (or
other institutions) to meet their financial obligations. A liquid company has no
difficulties with settling their accounts on time, while an illiquid one may have
problems with timely payment running the risk of insolvency. Thus, the lack of
liquidity is a possible bankruptcy reason and is therefore one of the central
issues in the corporate financial management. Liquidity of financial institutions
is of particular importance in this context insolvency in the banking system
could have serious economic consequences. Liquidity of companies depends on two
aspects: the availability of means of payment and the term structure of
liabilities. The first one can be understood twofold: as "cash on hand", i.e., the
balance on the corporate bank account available for making payments, or as the
ability to provide sufficient funds within a short period of time. While the
ability to meet obligations is given immediately in the first case, it may require
some time consuming and possibly costly actions in the second case. These may
encompass the sale of some of the company's assets, obtaining quick financing
through
29

See Garbade (1982), p. 422.


26

Chapter 1: The Concept of Liquidity

standing lines of credit or other financing facilities, or obtaining repayments


from outstanding accounts with customers. On the other hand, longer terms of
corporate liabilities leave more time for providing sufficient funding. The complex
character of corporate liquidity is also reflected in various liquidity ratios used
in financial analysis; among the most popular are:30

Cash Ratio =

Cash Current Liabilities


Current Assets - Inventories Current Liabilities Current Assets Current Liabilities

(1.1) (1.2) (1.3)

Quick Ratio =

Current Ratio =

Ensuring sufficient liquidity is the key task of short-term financial planning and
cash management.31 They encompass a wide field of problems ranging from the
formulation of exact financial plans on the basis of operating cycles to cash
budgeting. One of the central issues is the optimal size of cash holdings, or more
generally, the optimal financial slack. With an increased holding of cash or highly
liquid assets the risk of becoming illiquid and the "shortage costs" associated
with it the costs of emergency financing, loss of reputation, production
interruptions etc. are reduced. On the other hand, however, the opportunity costs
increase as no or only small interest is earned on these assets. The trade-off
between these types of costs is considered in numerous models to determine the
optimal balance of liquid assets (see Figure 1-6).32 However, considerations about
the optimal level of company's liquidity should also include such issues as the
availability of credit lines33 or the payment behavior of customers.

30 31

32

33

See Samuels et al. (1995), pp- 54-56, or Brealey et al. (2006), p. 792. See Brealey
et al. (2006), Chapter 31, Ross et al. (2005), Chapters 26 and 27, Moyer et al.
(1998), Chapter 16, Drukarczyk (2003), pp. 91-110, Rehkugler/Schindel (1994), pp.
210-225, as well as virtually any textbook on corporate finance. The inventory
model developed by Baumol (1952) is probably the most distinctive of the optimal
cash balance models. Better access to short-term financing facilities is one of the
reasons why larger firms with sound financial standing tend to hold lower liquid
asset balances while retaining high levels of solvency. See Moyer et al. (1998), p.
617.
1.1 Definition of Liquidity

27

Cost

Total costs

Holding costs

Shortage costs Optimal cash balance Figure 1-6: Optimal cash balance34 Cash

Only selected aspects of the wide subject of corporate liquidity could be discussed
in this section a full presentation is far beyond the scope of this work.
Nevertheless, it should be sufficient to give the impression of the complexity of
this issue. It depends on many factors. Some of them are exogenous, like the
payment behavior of customers or the availability of credit lines, but there are
also factors that can be influenced by the management, among them mainly the
holdings of cash and liquid assets. Thus, corporate liquidity is subject to
corporate policy.

1.1.1.4. Relations between the otions of Liquidity


Although the three different definitions of liquidity concern different areas of
economics, they are not unrelated. A link between them can be recognized even
intuitively. A closer look confirms that, in fact, they refer to the same basic
phenomenon. However, in each approach liquidity is viewed from a slightly different
perspective, and different aspects are put in the foreground, so that no full
identity is given. Consider the asset and market liquidity first. Obviously, liquid
assets are usually traded on liquid markets. For example, it is easier to sell an
asset quickly at a fair price on a market on which a large number of traders are
active. On the other hand, high liquidity of an asset induces more investors to
trade more frequently establishing a liquid market. Yet, despite this similarity,
the two approaches are not synonymous. In the
34

See Moyer (1998), p. 617, or Ross et al. (2005), p. 739.


28

Chapter 1: The Concept of Liquidity

first place, the focus of asset liquidity is on the situation of an individual


investor while market liquidity refers to the average situation of all investors.
This means that investors with different access to a certain market will also
perceive liquidity of assets traded on this market differently. Different time
preferences will also lead to different assessments of asset liquidity. In
contrast, market liquidity is independent of any individual investor
characteristics. Furthermore, while only the conversion into cash (i.e., a sale),
is important for asset liquidity, both sides of the market, the sellers' and the
buyers' side, are relevant for market liquidity. In consequence, the existence of a
liquid market should guarantee high liquidity of assets traded on this market, but
the opposite does not necessarily need to hold. Under certain circumstances an
asset can be liquid even if no liquid market for it exists.35 Moreover, in the
extreme case, it is even conceivable that asset and market liquidity contradict
each other: market A may be (objectively) more liquid than market B, but some
investors may consider the asset traded on the market A as (subjectively) less
liquid that the asset traded on the market B. Summing up, liquidity of assets seems
to be a more general concept than liquidity of markets. A link can be also
established between asset or market liquidity and corporate liquidity despite the
different focus of these approaches. Since it is only possible to meet financial
obligations payable in cash if sufficient cash is available, company's ability to
sell its assets quickly is crucial for maintaining liquidity. Hence, "one firm
would be considered more liquid than another firm if it has a greater portion of
its total assets in the form of current assets".36 In other words, a company that
holds a sufficient stock of liquid assets can be as liquid. Also in this case,
however, there is no perfect identity between the liquidity of the company's assets
and the liquidity of the company itself. As noted in the former section, the
availability of liquid assets is an important but not the only factor determining
the ability to meet financial obligations. The term structure of liabilities and
the access to credit lines are largely independent from the marketability of
assets, but they do influence corporate liquidity. Nevertheless, the availability
of cash is central to both approaches.

35

36

Units in open end funds can be named as examples for liquid assets without liquid
markets. Even if they are not publicly traded, they can be easily converted into
cash by reselling them to the fund. Besley/Brigham (1999), p. 539. An illustrative
example of the link between the grade of liquidity of the assets held by a company
and the probability of its insolvency is provided by Duffie/Ziegler (2003).
1.1 Definition of Liquidity

29

To sum up, although various definitions of liquidity are not quite equivalent, they
are closely related. In the core of the problem is the need for flexibility, i.e.,
the ability to decide about investments and disinvestments freely at any time
without bearing additional cost. Since the main mean of financial flexibility is
cash, all liquidity definitions are related to transactions against cash. Thus,
investors wish to be able to buy and sell according to their individual needs
independent of the circumstances. On the one hand, assets or markets that allow
them to achieve this goal have the quality of being liquid. On the other hand, a
company that is able to meet its obligations at any time at a low cost, i.e., is
able to act flexibly, is also considered liquid. 1.1.2. Liquidity Risk

In the former section, liquidity was treated as a quality of assets or markets,


which is more or less stable over time. However, a number of researchers noted that
it is not an unchanging constant. Most assets (apart from cash) and markets go
through phases of higher or lower ease of trading. Thus, there is definitely some
grade of uncertainty about liquidity, which should not be neglected by investors.
In this section, the definition of liquidity is extended to include this aspect,
which is referred to as liquidity risk. It can be identified with respect to both
asset and market liquidity. Although these two views generally refer to the same
issue, their character is slightly different. This difference is especially
distinct when considering privately traded assets on the one hand and public
markets with organized and centralized trading mechanisms on the other hand. The
discussion in this section is therefore structured according to this scheme.

1.1.2.1. Liquidity Risk of Privately Traded Assets


An indication of liquidity risk is already present in the Keynes' liquidity
definition cited in section 1.1.1.1, but it was highlighted by Hicks (1962) for the
first time. Hicks argues (p. 788) that the mere ability to sell an asset quickly
without discount, which he denotes as "marketability", is still not entirely
identical with liquidity itself.37 While marketability refers only to the expected
outcome of the sale, liquidity encompasses also the level of certainty about the
outcome. Thus, referring to the Keynes' original definition saying that one asset
is more liquid than another asset when it is "more certainly realizable at short
notice without loss"38, Hicks stresses the term "more certain37 38

See also Hicks (1974), Chapter 2, for an in-deep discussion of liquidity risk. See
FN 3.
30

Chapter 1: The Concept of Liquidity

ly". This certainty, or rather its lack, is here referred to as "liquidity risk" in
contrast to "marketability", which refers only to the expectation about the result
of the liquidation. In order to work out the precise meaning of liquidity risk,
consider first a hypothetical asset, which liquidity is known and constant over
time. As discussed in section 1.1.1.1 its grade of liquidity can be described in
terms of a price-time locus, which is depicted as an increasing curve in Figure 1-
1. According to it, a quick sale of an illiquid asset is only possible at a
discount to the fair value, but a higher price can be achieved if a time consuming
liquidation process is conduced. The price, which is referred to in this context,
is nominal. However, investors make decisions concerning future payments on the
basis of discounted present values. Given time preference expressed as a discount
rate, nominal prices can be discounted yielding a present value-time locus specific
for each seller. Since the nominal selling price is asymptotically approaching some
upper bound for long liquidation periods, its present value has to possess a
maximum for a finite duration of the selling process. Thus, there is some optimal
time topt that the investor should take to sell the asset in order to maximize its
present value (see Figure 1-7). The time topt is not only asset-specific but also
dependent on the investor's current situation in particular, it is shorter in
periods of higher time pressure when a higher discounting rate is applied.
Nevertheless, knowing the asset's typical nominal price-time locus, the optimal
liquidation time and the corresponding present value can be easily determined in
each situation. The liquidity discount corresponds then with the difference between
the maximal present value and the fair value. It depends only on the investor's
time preference.
1.1 Definition of Liquidity

31

Price

ominal value

Present value

topt

Time

Figure 1-7: Optimal liquidation time without liquidity risk

Note that liquidity is deterministic in this approach. Since there is no


uncertainty about the shape of the locus, the liquidation problem is trivial. The
time horizon should be set to topt in order to maximize the value of the asset and
minimize the discount. However, this case is obviously not very realistic. The
dependence between the realized selling price and the time necessary to achieve it
is by no means functional or deterministic. More likely, it is of stochastic nature
with the price-time locus being (at best) the set of expected liquidation values.
This means that longer marketing periods tend to lead to higher liquidation prices
but do not guarantee them. Suppose, for example, that a house is to be sold and
assume that the optimal liquidation time (e.g., 1 month) and the corresponding
price (e.g., $ 100,000) could be computed. Obviously, it is highly improbable that
the house will sell exactly at the targeted price after exactly one month of
selling efforts. Although it might be typical for such properties to transact at
about $ 100,000 within approximately one month, the seller can also be lucky to
find a buyer willing to pay this (or even a higher) price already during the first
week or be unlucky not to find one within a year. Thus, although some dependence
between the price and the liquidation time does exist, it is uncertain. The grade
of this uncertainty might be different for different assets, but it never
disappears entirely. The consequence of the stochastic character of the price-time
locus, illustrated in Figure 1-8 with the zigzag line, is the non-existence of an
unambiguous optimal liquidation time. A
32

Chapter 1: The Concept of Liquidity

typical or expected duration of the selling process might exist, but it will always
be burdened with uncertainty.39

ominal value Price

Present value

Time Figure 1-8: Liquidity risk as the uncertainty of the liquidation value

Above considerations make clear that it is essential to allow for uncertainty in


order to capture the full consequences of assets' illiquidity. Note, however, that
liquidity risk is not necessarily related to Hick's marketability represented by
the deterministic pricetime locus. While the latter one corresponds with the
(expected) dependence between the liquidation value and time, liquidity risk is
about the possible deviation from this expectation. In fact, it is the two-
dimensional nature what makes liquidity a practical problem. Ignoring the risk, as
it was done in the example at the beginning of this section, would result in a
deterministic optimal present value, which could be treated as equivalent to the
immediately receivable price of a perfectly liquid asset. There would be only
little economic difference between liquid and illiquid assets in such case. It is
the uncertainty about the liquidation outcome that makes liquidity so difficult to
include in investment decisions.

1.1.2.2. Liquidity Risk in Public Markets


Since asset liquidity and market liquidity are closely related, it can be expected
that liquidity risk also occurs on the market level. A closer look reveals,
however, that it
39

Similar considerations concerning the uncertainty about the liquidation outcome can
be found in several models of optimal liquidation; see, e.g., Almgren/Chriss (1998,
1999, 2000/2001) or Dubil (2002). See also section 4.2.1.
1.1 Definition of Liquidity

33

has a slightly different character from this perspective. Not the individual
uncertainty about a single transaction but the average uncertainty about all
transactions is important in this case. Moreover, liquid risk on the market level
can be unstable over time; thus, uncertainty itself is uncertain. It is the latter
aspect that is given special attencion in this section. The fact that liquidity is
not constant in public markets is obvious to most market practitioners. Even most
liquid assets, like popular securities or currencies, experience times when they
are more or less difficult to trade or are tradable at a higher cost than usual.40
This is illustrated on the basis of different liquidity measures in Figure 1-9 with
respect to large U.S. stock markets, which are considered to be among the most
liquid worldwide. Even without going into the precise meaning of these measures
this is done in Chapter 3 one can easily observe that the level of market
liquidity indicated by them fluctuates strongly both in the long and in the short
term. Furthermore, also the intensity of these fluctuations is not constant and
extreme outliers occur from time to time. One can expect the instability of the
liquidity level to be even stronger in less liquid markets. It may result from a
number of different sources. For one, technical matters such as opening hours of
major stock exchanges or fluctuations of prices around popular stop-loss levels
often cause short-term (intra-day) variations in liquidity. E.g., it is widely
known that trading becomes significantly more difficult (and costly) outside the
official trading times.41 Also changes in the number of liquidity providers may
affect market liquidity e.g., mergers between banks, who act as market makers in
many important markets, reduce the number of potential trading partners.42 Another
group of factors leading to varying liquidity refers to the general state of
economy. Chordia et al. (2001a) find that liquidity of US equity markets (measured
as trading activity) is influenced by variables such as interest rates or
macroeconomic announcements. Interestingly, they also report significant decreases
of liquidity in down markets but only slight increases in up markets. Furthermore,
several researchers state high levels of commonality in changes of liquidity
attributes, which may indicate common underlying (economic) determinants.43.

40 41 42 43

See Fernandez (1999) for a review of liquidity changes in various markets. See
Barclay/Hendershott (2004). See Richmond/Crawford (2003), p. 7 ff. See Chordia et
al. (2000 and 2005), Huberman/Halka (2001), or Hasbrouck/Seppi (2001).
34

Chapter 1: The Concept of Liquidity


a)

b)

c)

Figure 1-9: Variations of market liquidity on YSE and AMEX44

Summing up, varying liquidity is not unusual and has to be treated as a natural
state of economy. However, in some cases the variations may assume levels at which,
despite
44

Following measures have been applied: (a) quoted and effective bid-ask spread
[source: Chordia et al. (2001), p. 508], (b) illiquidity innovations (unexpected
changes) according to Acharya/Pedersen (2005) and (c) aggregate liquidity according
to Pastor/Stambaugh (2003).
1.1 Definition of Liquidity

35

the seemingly sufficient number of active traders, the ability of trading


disappears. Such situations are denoted by Persaud (2002) as "Liquidity Black
Holes" and may occur even in big markets due to the herd behavior or traders
attempting to sell or buy all at the same time.45 They result mainly from the lack
of diversity among traders, who similarly anticipate future price changes. Such
"Black Holes" could be observed, e.g., during the Asian financial crisis of 1997-98
or in a number of smaller turmoils after the Russian default in 1998. Such events
illustrate that uncertainty about the level of liquidity affects all public
markets. Moreover, the deviations from the normal state can assume levels at which
trading is impossible over longer periods of time. Thus, the consequences of
sudden, unexpected changes in liquidity are by no means marginal. Obviously,
uncertainty about market liquidity refers to all aspects of this feature. In
particular, it means that market breadth and market depth are also uncertain. Thus,
on the one hand, an investor willing to trade cannot be sure about the exact
selling price (bid-ask spread) at the moment of the trade; on the other hand, she
cannot be sure, whether she will be able to sell the whole amount at the quoted
price. In consequence, there is uncertainty about the impact of trading on the
price level and, accordingly, on the shape of the price-volume curve in the moment
of the transaction. These points are illustrated in Figure 1-10 with a zigzag
instead of a smooth line symbolizing the stochastic nature of the dependence
between the transaction volume and the realized price. Furthermore, the
decomposition of market liquidity into the exogenous and the endogenous component
implies that also liquidity risk can be split into exogenous and endogenous one.46
The former arises from the uncertainty about the normal level of liquidity (normal
market breadth), and the latter results from the uncertainty about the reaction of
the market price to the placement of a large order.

45

46

For an extensive discussion of Liquidity Black Holes see Persaud (2003) and a
number of papers therein. See, e.g., Jarrow/Subramanian (1997), Almgren/Chriss
(1998, 1999, and 2000/2001), and Bertsimas/Lo (1998), who focus on endogenous
liquidity risk, or Bangia et al. (1999), who address the exogenous liquidity risk.
36

Chapter 1: The Concept of Liquidity

Volume

Endogenous liquidity risk

Exogenous liquidity risk

Endogenous liquidity risk

Selling price

Purchasing price

Figure 1-10: Exogenous and endogenous liquidity risk47

Note that there is not necessarily a direct relation between the level of market
liquidity and the uncertainty about it. On the one hand, the fact that markets are
liquid does not mean that the high level of liquidity cannot fluctuate
substantially. On the other hand, highly illiquid markets may retain the same (low)
level of liquidity unchanged over longer periods of time. In effect, two largely
independent dimensions of market liquidity can be identified one referring to the
expected level of liquidity, and the other referring to the uncertainty about it.
They are analogical to marketability and liquidity risk identified for privately
traded assets in the former section. 1.1.3. A Two-Dimensional Definition of
Liquidity

The considerations in the former section introduced a new dimension to the


liquidity concept, which has only rarely been given attention in the literature on
this subject. Liquidity risk, viewed either on the level of assets or on the level
of markets, constitutes its integral part. Ignoring it, could lead to situations in
which an asset or a market would be falsely qualified as liquid although the level
of its liquidity would be highly uncertain. Incorporating this aspect in the
liquidity definition formulated in section 1.1.1 leads to an extended, two-
dimensional notion of liquidity, which is used throughout the analysis. Its main
features are summarized in this section. A scheme of the relations between the
respective terms is offered in Figure 1-11.

47

Based on Bangia et al. (1999), p. 5.


1.1 Definition of Liquidity

37

Asset Liquidity

Marketability (expectation about the liquidation outcome)

Time Price

Liquidity Risk (uncertainty about the liquidation outcome)

Market-wide factors affecting the outcome of liquidation

Characteristics of the investor

Randomness of the search process

Expected Liquidity (expectation about the ease of trading an arbitrary amount of an


assets)

Breadth Depth Resiliency

Liquidity Risk (uncertainty about the ease of trading an arbitrary amount of an


assets)

Market Liquidity

Figure 1-11: Structure of the two-dimensional liquidity definition

Since the main focus of this work is on illiquid privately traded assets, the
approach focusing on asset liquidity has been chosen as the starting point for the
further analysis. As already noted, its main feature is the explicit distinction of
marketability, defined as the expected outcome of a specific transaction, and
liquidity risk, defined as the uncertainty about this outcome. Both can be applied
to sales as well as purchases. Thus, if only a sale (liquidation) is addressed in
certain contexts, it is done only for convenience. In most cases, analogical
considerations can be applied to problems arising when buying an asset. The two-
dimensional liquidity definition can be further refined by analyzing the components
of the dimensions. Since the liquidation outcome refers to both the liquidation
price and the liquidation time, also marketability and liquidity risk can be
addressed this way. Hence, marketability can be understood as the combination of
the expected
38

Chapter 1: The Concept of Liquidity

effective liquidation value and the expected time required to achieve this value.48
Analogically, liquidity risk is the uncertainty about these two aspects.
Furthermore, the dimensions of asset liquidity can be traced to their sources.
Marketwide factors affecting the ease of trading by all investors in a similar
manner can be pooled into one category. On the one hand, the expectation about the
state of the market at the moment of the decision to sell constitutes the
marketability component. On the other hand, the uncertainty about the market state
is a source of liquidity risk. However, when liquidity is considered on the asset
level and viewed from the perspective of an individual investor, also her
individual characteristics influence the level of marketability and liquidity risk.
In particular, the ease (and the cost) of accessing the market or contacting other
market participants as well as the attitude towards time (time preference) and risk
(risk aversion) are of relevance in this context. Finaly, in the case of privately
traded assets, liquidity risk arises also from the fact that the search for a
trading partner is a random process. The structure of the definition of market
liquidity is roughly similar. Two dimensions can be identified here as well the
"expected liquidity" referrs to the expectation about the possibilities of a quick
liquidation of an arbitrary amount of an asset, and the "liquidity risk" referrs to
the uncertainty about these possibilities. Market liquidity can be further split
into three relevant aspects: breadth, depth, and resiliency of the considered
market. These are the characteristics of markets which determine the ease of
trading and, in particular, the relation between the prices that can be achieved in
transactions involving certain quantities of assets and the duration of the trading
process. Breadth, depth, and resiliency usually have some typical levels on
specific markets, but they are also subject to fluctuations. Considering the
sources of market liquidity leads to the conclusion that it is determined only by
general, market-wide factors. Neither individual characteristics of investors nor
the randomness of the search process affect is relevant in this case. This is
intuitively conceivable. Firstly, since market liquidity refers to the average
situation of all traders, it describes an objective feature of the considered
market any kind of individual information must therefore remain irre48

Note, however, that the distinction of the two components (time and price) is not
necessary as soon as a concrete investor with a well defined time preference is
considered. It is than possible to "translate" the time aspect of the transaction
into value by applying discounted prices. Nevertheless, for theoretical
considerations conducted on the abstract level, it may still be convenient to view
these elements separately.
1.1 Definition of Liquidity

39

levant. Secondly, the notion of market liquidity is usually applied to public,


centralized markets on which no individual search takes place. But even if the
search for a trading partner was possible and purposeful, its effects would be
cancelled out by the aggregation of transactions. Hence, while there are many
analogies between the dimensions of market and asset liquidity, one should not
consider them as fully interchangeable terms. Going deeper into the comparison of
the two approaches, reveals even more fundamental differences.49 Consider
marketability and expected market liquidity first. As discussed above, the latter
refers to the average "ease of trading" on the market. However, this does not mean
that expected market liquidity is equivalent to the average marketability of the
asset traded on the considered market. In fact, it also comprises the "expected
uncertainty" about the outcomes of transactions on this market. This is best
visible when analyzing the components of the bid-ask spread, the most widespread
measure of market liquidity uncertainty about the possibility of closing an open
position is priced by the dealer when setting the spread.50 Thus, expected market
liquidity contains not only the (average) marketability but, to some extent, also
the (average) level of asset liquidity risk. In consequence, market liquidity risk,
which is defined as the uncertainty about the level of market liquidity, contains
the uncertainty about the average marketability but also the uncertainty about the
average level of asset liquidity risk. On the other hand, as noted earlier, due to
the aggregation of individual transactions in the notion of market liquidity, all
kinds of individual investor characteristics or search effects, which are present
in the asset approach to liquidity, remain disregarded. The above discussion shows
that although the core of the liquidity problem remains the same, the precise
meaning of this term differs within different approaches. Thus, the choice of an
unambiguous definition is of crucial importance for the consistency of the
following analysis. The notion of liquidity assumed in this work builds mainly on
asset liquidity presented in section 1.1.1.1, which corresponds to a large extent
with the liquidity concept of Keynes. The definition is, however, extended to
include the purchase case as well. Thus, a liquid asset is one that can be bought
and sold quickly, at a good price, and with little uncertainty. References to
market liquidity, which appear in several contexts throughout the book, are based
on the definition provided
49 50

See also the discussion in section 1.1.1.4. See also section 3.5. See section
3.1.1.1 for the discussion of the components of the bid-ask spread.
40

Chapter 1: The Concept of Liquidity

above. Although it is not always possible to discuss the differences resulting from
following this approach, the reader should bear in mind that it is not fully
identical with asset liquidity. In contrast, the issue of corporate liquidity is
not further followed explicitly. However, since it is a function of the liquidity
of company's assets, it does not remain entirely disregarded. The complex concept
of liquidity presented in this section has important consequences for its
measurement as well as for including it as a decision criterion in asset management
models. In particular, it implies that the two dimensions, marketability and
liquidity risk, need to be considered separately. In consequence, the application
of multidimensional methods is necessary, what substantially increases the
complexity of the analysis. This issue is addressed in the following chapters,
especially in Chapter 3 and Chapter 4. Yet, before the development of concrete
methodical approaches can be undertaken, a closer look at the notion of liquidity
presented here is necessary. In particular, its determinants, which have been
mentioned only briefly in this subsection, require a more thorough examination

1.2.

Sources of Liquidity

The general definition of liquidity has been formulated and discussed in the
preceding section. According to it, liquid assets can be expected to sell more
quickly without substantial discounts opposed to illiquid ones, which liquidation
requires either time or the acceptance of less favorable prices. Moreover, not only
the expected liquidation outcome but also the uncertainty about it is relevant for
investment decisions. Hitherto, these issues have been considered only on the
abstract level, and assets have been assumed to have certain degrees of liquidity
by their nature. However, for an in-depth analysis, it is important to identify
factors which determine liquidity. Thus, the question "what makes an asset
illiquid?" is addressed in this section. Sources of liquidity are classified into
three groups, which should cover most of the important factors. These are:
transaction costs, organization of trading, and diversity of valuations. However,
before they are discussed in more detail, some general issues need to be clarified
in order to ensure a structured analysis.
1.2 Sources of Liquidity 1.2.1. Preliminary Considerations

41

Before the sources of liquidity are discussed in detail, it is necessary to


identify the channels through which the characteristics of assets, markets, and
market participants affect the ease of trading. The starting point is the
definition of asset liquidity provided earlier in this Chapter in section 1.1.1.1.
In order to be able to sell quickly and without discount, two conditions need to be
fulfilled: 1. The investor has to be able to meet a buyer willing to purchase the
asset; quick liquidation is technically impossible otherwise. 2. The duration of
the liquidation process should have no or only little impact on the (nominal)
transaction price. The above conditions refer mainly to marketability. With respect
to liquidity risk, the third condition can be formulated: 3. The outcome of the
liquidation process should be predictable to some extent. When selling or
purchasing an asset is impossible, its liquidity is per definition zero. Such
situations are often feared by investors; however, true "unsalability" is
relatively seldom. By saying that a mansion, a painting, or a luxurious car is
impossible to sell, the owner usually means that it is impossible to sell at the
desired price. In most cases, such assets could be liquidated if the price
requirements were (substantially) lowered. According to this logic, everything can
be sold; the question is only at what price. Same applies to the purchase problem
nearly everything can be bought if a sufficiently high price is offered. The rare
cases of true "unsalability" (or "unpurchasability") encompass mainly situations in
which trading is legally restricted. This refers, on the one hand, to "assets"
which are definitely excluded from being sold or bought or even owned human
beings belong to this category. On the other hand, trading restrictions may be laid
upon some otherwise tradable goods national currencies are sometimes subject to
such regulations. However, since these cases are rather exceptions in the day-to-
day investment activity, they are disregarded in further considerations; the first
condition can therefore be considered as fulfilled. The sources of asset liquidity
are, thus, to be seeked among factors affecting the duration of the marketing
process and its outcome. The main one is the way buyers and
42

Chapter 1: The Concept of Liquidity

sellers search, find each other, and agree on prices.51 When the search can be
accomplished quickly, i.e., it is possible to identify a potential trading partner
with an acceptable price limit within a short period of time, liquidity is (ceteris
paribus) higher than when longer search is required. Also the impact of the search
process on the final transaction value is relevant. In this context, two main
factors affecting the character of search can be identified: the number of
potential trading partners on the market (market depth) and the flow of information
about trading possibilities between market participants. They should be given a
closer look. The more investors are interested in buying or selling, the better are
the chances of finding an acceptable offer quickly. The number of potential buyers
or sellers is, however, not exogenous and depends on a number of factors. To some
extent, it depends on the characteristics of the asset itself. Some goods, like
rare collectibles, have a positive value only to a limited number of individuals;
other goods, like cars, are widely used and demanded by larger groups. However,
this criterion is of little relevance with respect to financial assets, i.e.,
assets held only for the purpose of generating returns. Since only this kind of
assets is regarded in this work, their intrinsic utility is irrelevant for further
considerations. It can be realistically assumed that every investor would be ready
to buy (or to sell) any asset if it offered her sufficient profitability. Hence, in
the ideal case, the number of potential market participants should be a function of
expected (risk adjusted) returns. Among the numerous factors which affect assets'
return characteristics, transaction costs are especially relevant for liquidity
considerations.52 Due to their one-time character, they affect short term
investments stronger than long term investments and discriminate frequent trading.
In consequence, trading activity should be weaker in markets with higher
transaction costs. Similar effects can be caused by organizational obstacles,
especially by formal requirements affecting the speed of executing transactions,
and by imperfect divisibility of assets, which prevents optimal allocation of
capital.

51

52

The role of search in the organization of trade and liquidity of markets is


discusses in Harris (2003), pp. 394 ff. To be more precise, market imperfections,
of which transaction costs are an important part, are the main source of
differences in risk adjusted returns. Theoretically, if there were no obstacles in
the access to markets or information, arbitrage should lead to identical returns on
all investments. Frictions preventing such "perfect markets" result in differences
in returns. See e.g. Fama/Miller (1972), p. 21, or Fabozzi/Modigliani (2003), p.
109.
1.2 Sources of Liquidity

43

A different reason for difficulties in finding a trading partner is the lack of


knowledge about his existence, or more precisely, the high cost of gaining such
knowledge. This problem is best illustrated by the comparison of financial markets
hundred years ago and today. The informational revolution enabled investors to
conduct transactions with individuals on the other side of the globe of whose
existence they would otherwise never learn; this led to the globalization of
markets. Aside from the technical issues, also the form of market organization
plays a big role in providing means of contact between buyers and sellers. It
includes, in particular, the existence of institutions assisting market
participants in their search efforts. Due to professional organization, economies
of scale, and similar factors such institutions may be able to substantially reduce
the cost of searching for trading partners. Finally, differences in opinions about
the fair value of an asset will also influence the ease of finding a trading
partner. Suppose that an investor wishes to sell a share of a company and is
certain that its value (arising from expected future earnings) is no less than $
120, while other investors on the market value it between $ 90 and $ 110. Since the
investor would rather not sell at all than sell below the believed true value, she
will not be able to find an individual with whom she could agree on the sale price.
On the other hand, if the range of valuations by market participants was between $
75 and $ 125, a chance of finding a suitable buyer would exist. To sum up, it seems
that it should be easier for an average investor to find a trading partner offering
an acceptable price when beliefs about the true value vary stronger. However, with
a larger spread of valuations also the uncertainty about the outcome of the
liquidation is higher, i.e., liquidity risk increases. The above discussed factors
affect the average (expected) marketing time and the realized transaction price,
i.e., the liquidity price-time locus of an asset as well as the uncertainty about
its shape. Transaction costs lower the liquidation value and lead to less frequent
trading; trading mechanisms determine the duration of the transaction process and
are also crucial for the evolution of prices; finally, the divergence of opinions
about the value of an asset is important both for the chances of finding a trading
partner and for the predictability of realized prices. In view of the importance of
these three groups of factors, they are discussed more thoroughly in the following
subsections.
44 1.2.2. Transaction and Opportunity Costs

Chapter 1: The Concept of Liquidity

In most cases, investors are able to trade assets only at a certain cost. The
existence of such costs is often associated with liquidity. In fact, many
researchers go as far as to set an equality sign between these terms.53
Schwartz/Francioni (2004, p. 63) state even that "illiquidity and trading costs are
two sides of the same coin". As discussed further in this section, this opinion
seems to be justified only with respect to certain types of transaction costs and
even then not unconditionally. Furthermore, it seems that the literature on the
postulated link between liquidity and transaction costs often fails to distinguish
the costs that affect liquidity from the costs that are the effect of lacking
liquidity. This section attempts to clarify some of these issues. Transaction costs
may have a number of different forms. They are usually classified into direct
commissions and a broad group of indirect costs.54 The latter ones encompass, in
particular, the bid-ask spread and the market impact. Also opportunity costs of
trading are often considered to be a form of transaction costs.55 From the trader's
point of view, all these costs have a similar effect they result in the payment
made at purchase being effectively higher and the payment received at sale being
effectively lower than the nominal price of an asset. Consequently, they can be
referred to as a premium or a discount on the asset`s current (fair) market price.
However, depending on the origin of the costs, their impact on liquidity is
different.

1.2.2.1. Commissions and Taxes


Various commissions, which need to be paid in order to trade, constitute the most
distinctive part of direct transaction costs. This diverse category encompasses a
number of various payments resulting from different sources. Most often are
different types of legal fees charged by notaries or other administrative bodies
for legal procedures as well as brokerage and intermediation fees necessary to
obtain access to markets. They
53

54 55

This is indicated by the presentation of the subject of transaction costs in


chapters on financial market liquidity (or the subject of liquidity in chapters on
transaction costs) in many finance text books, as, e.g., Francis/Ibbotson (2002),
pp. 151 ff., or Schwartz/Francioni (2004), pp. 63 ff. Also a lot of "journal"
research uses these terms as exchangeable; see Marschak (1949, 1950),
Constantinides (1986), Grossman/Miller (1988), or Grossman/Laroque (1990) as well
as the literature in FN 294, 295, and 296. See Fabozzi/Modigliani (2003), pp. 259
ff., or Wagner/Edwards (1993), p. 67. See Schwartz/Francioni (2004), p. 66,
Fabozzi/Modigliani (2003), p. 262, Francis/Ibbotson (2002), p. 151, or
Maginn/Tuttle (1990), p 12-35.
1.2 Sources of Liquidity

45

vary strongly depending on the type of asset or market and range from negligible
amounts to substantial portions of invested capital.56 Another important category
of direct trading costs consists of various taxes. On the one hand, turnover-based
taxes are imposed on certain assets e.g., the land transfer tax belongs to this
category, but also the definitive value added tax (if applies) must be treated as a
transaction cost. On the other hand, various income taxes have a similar effect.
Since they are imposed on (positive) capital gains, they affect the effective sale
prices of assets, which yield positive holding period capital returns. The above
mentioned costs arise from clearly defined regulations and are, at least to some
extent, time invariant. The fact that direct transaction costs can be determined
with certainty before a transaction is carried out is one of their most important
characteristics they constitute the fixed component of the total trading costs.57
The impact of direct transaction costs on liquidity is less straightforward than it
may seem at first sight. The analysis in this section is therefore conducted in
several steps. Consider first the introduction of a transaction fee (commission)
from the perspective of a single investor holding an asset as a capital investment.
The effect of such a fee on the asset's liquidity depends on whether it is levied
as a fixed amount or proportionally to the size of the transaction. As it seems, a
direct liquidity effect occurs only in the first case. It is best illustrated on
the basis of the price-time locus of liquidation. Liquidity, or more precisely
marketability, has been defined in this context as the slope of the respective
curve (see also Figure 1-1). While liquid assets can be liquidated quickly at the
fair value, so that their liquidation prices increase quickly with the duration of
the liquidation process, achieving the maximum possible price for an illiquid asset
requires more time resulting in a slow increase of the price. The introduction of
the commission results in an immediate downward shift of the whole locus as
illustrated with the grey line in Figure 1-12. Note, however, that not the position
of the locus but only its shape (slope) is relevant for the asset's marketability.
Thus, in order to correctly assess the effect of the commission, it is necessary to
relate liquidation prices resulting at different liquidation periods to the maximum
achievable price after the commission and not to the one that could have been
gained before the commission was introduced. In other words, it is the price-time
relation that matters in marketability considerations and not the level of prices.
Since a fixed fee accounts for a larger
56 57

See sections 1.3.2, 1.3.3, and 1.3.4 for empirical examples. See Collins/Fabozzi
(1991), p. 27.
46

Chapter 1: The Concept of Liquidity

fraction of the lower prices at the beginning of the liquidation than of the higher
prices resulting at longer liquidation periods, the "after-commission" relative
price-time locus lies below the original one. The dotted line in Figure 1-12 shows
the shape of the locus scaled to the new (lower) maximum achievable price. It
clearly implies lower marketability.58

fixed commission

Price

max

----

original locus (unscaled) after-commission locus (unscaled) after-commission locus


(scaled) Time

Figure 1-12: The effect of a fixed commission on the price-time locus of


liquidation

In contrast, a proportional commission has no effect on the relative price-time


locus. For example, if extending the duration of the liquidation process results on
average in an x% higher sale price, the proportional gain will be the same with a y
% commission on the realized price. Thus, marketability is not affected by a
proportional commission. Same holds also for liquidity risk. While a fixed fee
leads to higher uncertainty about the realized price, especially for shorter
liquidation periods, a proportional commission has no effect on the fluctuations of
relative prices liquidity risk remains unchanged. The above conclusions refer to
liquidity of assets and hold for commissions or taxes imposed on the level of
single investors. However, there is another, less direct effect on liquidity, which
can only be recognized when a market is considered as a whole, i.e., as an
interaction of numerous investors. Commissions applying to all traders affect
58

Note, however, that there would be no liquidity effect in the described sense if
the asset was perfectly marketable before the introduction of the commission, i.e.
the same price could be achieved independent of the liquidation time. Introducing a
fixed commission in this case reduces the achievable price, but it still can be
achieved immediately, so that formally marketability remains perfect.
1.2 Sources of Liquidity

47

the price-time loci of their individually held assets, but they also determine the
profitability of frequent trading. The cost of buying and selling an asset directly
influences its holding period return. Thus, quick liquidation may not be favorable
even if the liquidation price is independent of the liquidation time, i.e., the
locus is flat, but lies below the purchasing price. Higher direct transaction costs
result in effectively lower returns of short-term investments enforcing longer
investment horizons and leading, in consequence, to less frequent trading. Hence,
they lead to lower trading volumes and reduce market depth.59 For an individual
seller, this means a lower chance of meeting a trading partner willing to trade at
a certain price and, thus, the necessity of accepting either a longer duration of
sale or a lower price. Note, however, that this only holds when all market
participants are affected by the direct transaction cost in the same manner
discriminating commissions or taxes applying only to individuals or to small groups
of investors have no such effect. The above discussion makes clear that the
liquidity effect of commissions comes less through the direct reduction of the
realizable sale price the most popular proportional commissions have no impact on
liquidity on the level of individual assets but mostly indirectly, through the
reduced intensity of trading on the affected market. This conclusion concerns in
the first place marketability (expected liquidity); the effect on liquidity risk is
less obvious. There seem to be no straightforward argument why less frequent
trading as such should lead to higher uncertainty about the realized sale or
purchase price (marked to market). An increase in the overall investment risk is,
however, probable due to higher exposition to market risk with longer intervals
between trades it is more difficult to react to new information.60 This additional
market risk arising from direct transaction costs can, and in fact should, be
viewed as a part of liquidity risk. However, since it is essentially identical with
the risk arising from opportunity costs, it is discussed more thoroughly in section
1.2.2.3.

59

60

The formal model by Lo et al. (2004) leads to an analogical result. In the presence
of fixed transaction costs heterogeneous agents, who would trade continuously in a
frictionless market in order to hedge their non-tradable risks, choose to trade
only infrequently. The inability to trade at will results in a reduced demand for
the asset and gives rise to significant liquidity discounts. The analysis of
various measures of liquidity risk introduced in section 3.3 generally confirms
this link. In particular a higher variance of the net receipts from liquidation
arises when lower trading intensity (arrival of offers) is assumed.
48

Chapter 1: The Concept of Liquidity

1.2.2.2. Indirect Transaction Costs


Indirect costs of trading, which consist mainly of the spread between the buying
and the selling price (bid-ask spread) and the impact of trading on the market
price, constitute a separate group of transaction costs discussed in the
literature. Although these costs are less explicitly visible than direct
commissions, they often outweigh them61 Wagner/Edwards (1993, p. 67)
illustratively refer to direct transaction costs as to the "top of the iceberg" of
total transaction costs consisting mainly of the indiect ones. They are sometimes
presented in form of the cost of a "round-trip", i.e., the total cost of a
simultaneous purchase and sale of an asset.62 This approach allows assessing the
portion of the asset's value that an investor forfeits in the investment process
due to factors other than pure changes in supply and demand. Demsetz (1968) was
probably the first to refer to the bid-ask spread in terms of a transaction cost.
In the strict sense, the spread defined as the difference between the selling and
the buying price exists only in dealer type markets, i.e., in markets in which a
specialized dealer or market maker publicly quotes prices at which he is ready to
trade. On the other hand, also many directly traded assets with no organized
trading systems may demonstrate some kind of a spread. For real estate,
collectibles, or second-hand cars average prices are usually higher for buyers
willing to buy quickly than for sellers willing to sell quickly. This arises from
the fact that the active party, i.e., the one actively searching for a trading
partner, is usually under a higher pressure to transact and has less bargaining
power than the passive one. Another component of the indirect cost is the impact of
trading on the market price. Especially in shallow but wide markers selling or
buying larger quantities is only possible by falling back on individuals asking or
bidding less favorable prices. Thus, an attempt to execute a large transaction
leads to an adjustment of the market price forcing the trader to sell at a lower
price or to buy at a higher price than usual. This applies especially when the
transaction is to be executed quickly with sufficient time, an investor can split
the order into several smaller ones avoiding the reduction of the market price.
Thus, the market impact can be treated as the (additional) cost of trading large
amounts quickly.
61

62

See, e.g., the empirical data in Loeb (1983), Sharpe/Alexander (1990), pp. 52-53,
Jones (2002), or Schwartz/Francioni (2004), p. 66-67. Note, however, that virtually
all empirical studies refer to publicly traded equities. The assessment of indirect
transaction costs for other assets, in particular for real estate, is hardly
possible. Ibidiem.
1.2 Sources of Liquidity

49

For an individual investor, the bid-ask spread and the market impact have similar
effects to commissions or taxes the effectively realized purchasing price is
higher and the selling price is lower than the mid-price, which would result
otherwise. This analogy allows analyzing the effect of indirect transaction costs
on the price-time locus in a similar manner. From the point of view of an
individual investor, the spread, which is proportional by its nature, affects the
absolute price-time locus of an asset but not the relative one; i.e., marketability
on the individual level remains unchanged. However, higher "round-trip" costs
reduce returns from short term investments and prevent frequent trading leading to
less market activity and lower market depth. In contrast, the existence of the
price impact forces investors willing to maximize assets' sale prices to liquidate
larger quantities over longer time periods. Hence, the liquidation value increases
more slowly over time indicating lower marketability. These conclusions demonstrate
that liquidity effects of direct and indirect transaction costs are to a large
extent analogical when referring to marketability (expected liquidity). The
difference is more substantial with respect to liquidity risk. While there seems to
be no clear reason, other than opportunity costs, why commissions or taxes should
increase the uncertainty about the outcome of liquidation, it is different with
respect to indirect costs. Unlike commissions, spreads and price impacts are not
predetermined and their precise magnitudes depend on the decision of a dealer or on
the reaction of a market. Both these determinants are associated with uncertainty
even shortly before the transaction one cannot be absolutely sure about the
effectively realized price. The final effect of the spread and the market impact is
always burdened with additional uncertainty. Thus, the existence of indirect
transaction costs increases assets' and markets' liquidity risk. A closer look at
the origin of indirect transaction costs reveals another, even more substantial
difference to the direct costs. While the latter are exogenously enforced by
authorities, it is much more difficult to identify one unique source of the
indirect costs. In fact, it seems that they are determined to a large extent by the
same factors as liquidity itself. For example, Keim/Madhavan (1998) classify the
determinants of (equity) trading costs into stock-specific factors, like relative
(not precisely defined) liquidity, stock volatility, market design, and traders
skills and reputation, and transactionspecific factors, like order size, order
type, and investment style. Note, that most of these factors are discussed in
subsequent sections as the actual sources of liquidity
50

Chapter 1: The Concept of Liquidity

(marketability and liquidity risk). Also, a number of market microstructure models


address the sources of the bid-ask spread and the market impact coming to similar
conclusions. For example, the spread in the models of Stoll (1978) and Ho/Stoll
(1981) is determined by the costs of order processing and the costs of holding an
inventory; these costs correspond with the direct trading costs discussed earlier
and the opportunity costs discussed later, respectively. Garman (1976) concentrates
on the role of the stochastic nature of supply and demand in setting the bid and
ask prices, which is related to the problem of (random) search for the trading
partner discussed in section 1.2.3.2. Finally, models of Copeland/Galai (1983),
Glosten/Milgrom (1985), or Kyle (1985) focus on the impact of information asymmetry
on the bid-ask spread, which seems to show some analogy to the impact of
heterogeneous valuations among market participants discussed in section 1.2.4. The
similarity of the sources of indirect trading costs and liquidity justifies their
treatment by numerous researchers as two (nearly) exchangeable terms. Indeed, if
one assumed that there were no indirect costs of trading in a perfectly liquid
market, all such costs incurred in reality could be attributed to the lack of
perfect liquidity making these two concepts equivalent. This approach was
postulated by Miller (1965) who noticed that both the price and the time dimension
of the liquidation process can be expressed in money units and interpreted as costs
as soon as time is considered valuable.63 However, a more rigorous analysis raises
some doubts about the nature of this link. Firstly, a reference point is necessary
in order to translate asset's present value into cost a cost means a reduction of
the value, but from what basis? At least several possibilities seem plausible here:
the presumable fair value in the state of perfect liquidity, the maximal achievable
value, and the value realized in the case of an immediate liquidation. Each of
these alternatives leads to a different notion of transaction costs and liquidity,
and it is unclear which of them is most accurate. Secondly, Miller's postulate of
equivalency between indirect transaction costs and liquidity seems to refer mainly
to the expected liquidation outcome; liquidity risk is not explicitly mentioned.
Theoretically, uncertainty about the outcomes of individual trades should be
reflected in indirect trading costs to some extent; in particular, it should be
prices in the bid-ask spread. However, the exact mechanism is still not clear and
empirically little researched. The cited market microstructure models contribute a
lot to the explanation of

63

This approach is referred to as the present value-time locus in sections 1.1.1.1


and 1.1.2.1.
1.2 Sources of Liquidity

51

this problem, but doubts about full equivalency between indirect transaction costs
and liquidity still remain. To sum up, despite the seemingly similar effects for
individual investors, the relation between indirect transaction costs and liquidity
is significantly different from the relation between direct costs and liquidity.
While commissions and taxes constitute only one of the factors determining the ease
of liquidation, indirect costs seem to refer to the same phenomenon as liquidity
itself. Thus, one can either consider indirect costs to be the consequence of
lacking liquidity or illiquidity to be the result of high indirect costs of
trading. In any case, both terms are closely related, although more research would
be necessary to state whether full equivalency is given. Avoiding further extensive
discussion of this subject, the analysis concentrates on liquidity understood
primarily as the "ease of liquidation" rather than the "cost of liquidation".
Consequently, indirect transaction costs are treated mainly as the result and not
the source of liquidity.

1.2.2.3. Opportunity Costs


The importance of opportunity costs has been already mentioned in the context of
introducing liquidity risk in section 1.1.2.1. Although they are often classified
as indirect transaction costs, it is reasonable to discuss them separately.
Opportunity costs can be most simply described as the "costs of waiting". They
denote all losses incurred and gains missed that would have been avoided or
achieved if the transaction had been accomplished earlier than it actually was.
Despite the common caption, this group of costs is not homogenous and (at least)
two types of opportunity costs can be identified.64 The first one refers to the
effects of postponing a transaction on the effectively realized price; the second
one encompasses the consequences of missing alternative investment opportunities.
While searching for better liquidation (or purchase) possibilities, investors run
the risk that the market situation may change. This change may be both to
investor's advantage as well as to her disadvantage. However, assuming that the
moment of liquidation is not chosen accidentally and that the investor follows a
timing strategy, delaying the
64

A number of various classifications of opportunity cost can be found in the


literature; in particular, they are often classified as indirect transaction costs
(see Keim/Madhavan, 1998, p. 54 ff., Francis/Ibbotson, 2002, p. 151, or
Schwartz/Francioni, 2004, p. 66). The approach followed in this section is
especially purposeful for the analysis in the following chapters.
52

Chapter 1: The Concept of Liquidity

trade will possibly corrupt this strategy. This type of opportunity costs is
usually referred to as timing costs and this term is also used in this book.65
However, researchers usually fail to differentiate between its two separate
components: the expected market development during the liquidation process and the
additional uncertainty arising from unexpected market fluctuations, i.e.,
additional market risk. The fist one means that postponing the sale can be
advantageous in bull markets with expected price increases but disadvantageous in
bear markets, where prices tend to fall (the opposite holds for the purchase case).
Thus, the expected cost of a delayed liquidation can be either negative or
positive.66 In terms of the (expected) time-price locus of an asset, marketability
is higher in the former case and lower in the latter case in comparison to the
situation of absolute price stability. Additional market risk is, however, incurred
in either case. It results in a higher uncertainty about the terminal value of an
investment. Although its nature is the same as that of the "regular" market risk,
i.e., the uncertainty about the change in the value of an asset within the
investment horizon, it seems to make more sense to attribute it to liquidity risk
rather than to market risk. In consequence, the market timing effect leads to an
increase in liquidity risk. Its level depends on the level of asset's price
volatility on the one hand and on the frequency of trading possibilities, i.e., the
frequency of sale or purchase offers, on the other hand. The chance of a
substantial change in the market price level is higher in more volatile markets
than in more stable markets, but with more opportunities to trade the liquidation
process can be accomplished more quickly reducing the exposure to these changes.67
A different type of opportunity costs are the benefits that could have been gained
if the transaction had been completed more quickly it is referred to as the
opportunity cost in the narrow sense. Such costs arise both in the sale and in the
purchase case. The rea65 66

67

See Collins/Fabozzi (1991), p. 28, or Wagner/Edwards (1993), p. 68. A practical


approach to capture market timing costs is the "implementation shortfall" proposed
by Perold (1988), which is computed as the difference between the notional return
that would be earned if an order was executed immediately and the actual return.
Perold states that this type of costs constitutes a substantial portion of the
total transaction costs, what is also confirmed by Keim/Madhavan (1997).
Schwartz/Francioni (2004, p. 69-70) note that low liquidity alone can affect the
volatility of prices in certain markets. Prices in such markets may tend to
"bounce" between higher values paid by buyers and lower values received by sellers;
lower trading activity also results in larger errors in price discovery (i.e.,
finding an equilibrium price through trading). Since, as argued above, higher
volatility means higher liquidity risk and, thus, lower total liquidity, the whole
process might be to some extent self-accelerating. This issue is not further
followed in this book leaving an interesting field for further research.
1.2 Sources of Liquidity

53

son for selling an asset is always the ability to use the capital in a more
efficient way this could be an attractive investment opportunity, repayment of
depth, or consumption. Independent of its type, the alternative use of capital is
viewed by the investor as more valuable than the income from the original
investment. Thus, by continuing the ownership of the latter one unwillingly, for
example, due to the inability to trade, she misses the benefits of the
alternative.68 On the other hand, assets are purchased because the gains from
owning them are higher than the gains from the current allocation of capital;
delaying the purchase results in the loss of these gains. Note, however, that in
both cases it would be incorrect to define all resulting losses as opportunity
costs only the difference between the desired and the actual state is an
effective cost. In the sale case, it is the difference between the alternative use
of capital (e.g., the rate of return of an alternative investment) and the gains
provided by the asset scheduled for liquidation. Analogically, the difference
between the current use of capital and the gains provided by the asset constitute
the opportunity cost in the purchase case. With respect to financial assets,
opportunity costs in the above sense are usually allowed for by discounting future
payments. While the level of market timing costs depends solely on the
characteristics of assets and markets, opportunity costs in the narrow sense are a
function of investor's individual situation. Obviously, the availability and the
type of alternative uses of capital differ not only among investors but also change
with time. There is therefore no universal, always valid discount rate that can be
used to allow for these costs; it needs to be set by each investor individually
according to her current situation. In this context, it is useful to differentiate
between two situations, which with high probability lead to significantly different
opportunity cost levels. The first one is a liquidation (or a purchase) that has
been anticipated and is a part of the investment strategy. This is the case when
the investment goal has been achieved or the planned holding duration of an asset
has been reached. The sale of stocks from a portfolio, which has been optimized for
one year holding time, or the sale of an accomplished real estate project by a
developer are examples of planned liquidations. In this case, there is usually no
urgent need for a quick sale. The difference between the alternative uses of
capital, like a new
68

Baldwin/Meyer (1979) provide an excellent demonstration of how opportunity costs in


the narrow sense affect liquidity. They model the situation of an investor who
commits to an illiquid investment not knowing whether a more lucrative opportunity
arrives later (opportunities arrive in a random sequence). The central conclusion
is that a larger liquidity premium should be demanded for longer-lasting
investments in order to compensate for lost opportunities.
54

Chapter 1: The Concept of Liquidity

equity portfolio or a new development project, is not excessive, so that the


investor can take more time to optimize the liquidation process. In consequence, a
lower discounting rate can be applied. A substantially different situation arises
when the liquidation is unexpected, i.e., forced by external circumstances. This is
usually the case in times of liquidity bottlenecks, when events such as a sudden
default of a large debtor or cancellation of a credit line rapidly increase
investor's demand for cash. Failure to gather the required funds on time results
usually in a default on own liabilities and, in consequence, in insolvency. It is
therefore highly probable that the opportunity cost of postponing the sale is
significantly higher in such cases than it would be if the sale was expected and
planned. In particular, the investor might be forced to fall back on expensive
emergency financing or even accept bankruptcy costs. Note, however, that the
latter, although high, are not infinite;69 thus, it might be preferable to accept
bankruptcy rather than to liquidate an asset far below the normally achievable
price. Analogical considerations can also be applied to the purchase case. It may
sometimes come to situations when the necessity of buying arises unexpectedly,
e.g., when an option for delivery of securities or commodities is executed. The
cost of the inability to deliver is then most probably far above the one faced in
the case of a scheduled purchase. The differentiation between a planned and a
forced liquidation is of high relevance for liquidity management and is discussed
in several contexts in this work. Probably the most important conclusion arising
from the discussion of opportunity costs is the subjectivity of this parameter. The
fact that each investor sees a different set of opportunities results in
differences in personal valuations of the receipts achievable at sale or
expenditures necessary for purchase. Obviously, those with better alternative
investment possibilities should put more weight on the time aspect the optimal
liquidation time will be shorter for them than for investors with poor investment
opportunities. Analogically, individuals facing sudden liquidity bottlenecks will
be more prone to sell quickly, even accepting a substantial discount, than those
who planned the sale earlier and are less in hurry. In consequence, the grade of
assets' liquidity will differ depending on the individual situation of the investor
and the opportunity costs related with it. This is best illustrated with a
comparison between a bank savings account and a piece of fine jewelry. The savings
account can be liquidated at any time at the nominal value; it may take, however,
up to several working days before the amount
69

The assessment of bankruptcy costs meets on numerous practical problems; see Kalaba
et al. (1984) or Bris et al. (2006) for approaches to this problem.
1.2 Sources of Liquidity

55

is available in cash. On the other hand, jewelry can be sold (pawned) immediately
against cash, but the seller usually has to sacrifice a substantial portion of the
value achievable in a regular sale. To most people in common everyday situations,
the savings account is far more liquid than jewelry. However, if an individual
faces a situation in which she urgently needs cash within one day facing severe
consequences otherwise, jewelry may prove to be more liquid than the savings
account; the latter may, in fact, seem perfectly illiquid in this situation. Thus,
the level of opportunity costs is highly relevant for asset liquidity and its
subjectivity makes also liquidity a partially subjective characteristic of assets.
1.2.3. Market Organization and the Search for a Trading Partner

A subject that is often discussed in the context of market and asset liquidity is
organization of trading. Central issues include, on the one hand, the way sellers
and buyers are brought together to trade and, on the other hand, the way price
agreements are reached. Their relevance is straightforward they affect the time
necessary to accomplish a transaction as well as the price effectively realized;
consequently, they affect the price-time locus of liquidation. Before conducting a
closer analysis of the role of market organization for liquidity, it is purposeful
to review its main existing forms. They differ not only with respect to the
technical procedures involved but also with respect to the character of the search
for a trading partner. The latter aspect turns out to be of key relevance for
liquidity and receives therefore special attention.

1.2.3.1. Forms of Market Organization


The numerous various approches to the organization of trade can be classified in
four main groups: direct search markets, brokered markets, dealer markets, and
auction markets.70 The first two can be associated with less structured trading and
are referred to as non-organized markets, and the latter two are characterized by
the existence of specialized institutions assisting investors in their trading
activity and are referred to as organized markets.

70

This classification is based mainly on Garbade (1982), Part 7, but similar ones can
be found in most handbooks on security markets; see, e.g., Reilly/Brown (1997),
Chapter 4, Santomero/Babbel (1997), Chapter 19, or Fabozzi/Modigliani (2003),
Chapter 7. Although it originally refers to stock trading, same principles are also
valid for other assets.
56

Chapter 1: The Concept of Liquidity

Traders in direct search markets (also referred to as direct markets) act on their
own in their efforts to find a trading partner. This form of market organization is
most common on markets for rarely traded goods but also on markets for goods that
are difficult to standardize in a large scale. Among them are many commodities,
arts, wine etc. Also real estate as well as shares of smaller companies are widely
traded in direct markets. The lack of organized trading structures induces the
necessity of contacting each potential buyer (when selling) or seller (when buying)
individually and negotiating the price separately in each case. Due to the
relatively high cost of reviewing trading opportunities, it is seldom economical to
conduct the search among all potential partners. The result is therefore more or
less dependent on the luck of meeting the right one quickly. High search costs and
the lack of reliable information about trading possibilities are doubtlessly the
main weaknesses of direct markets. However, this type of market organization does
not only have disadvantages. Firstly, it enables individuals with strong bargaining
positions to negotiate relatively better prices. Secondly, it does not preclude
finding a trading partner offering above-average conditions. Due to the latter
property, it is possible that transactions are executed which would never come to
execution under a different market regime. The lack of complete knowledge about the
current market situation by all market participants may, thus, be advantageous for
some of them, particularly for those with better market overview. A natural further
step in the development of direct search markets are brokered markets in which
brokers offer search services to individual investors. This allows a reduction of
search costs. However, there will only be demand for such services if economies of
scale occur, i.e., if brokers are able to search at a lower cost than individuals.
There are a number of possible reasons why this can be the case in certain markets.
Firstly, specialized information channels are often available against a fixed fee.
By utilizing them to conduct a larger number of searches, the unit cost of
obtaining information about a potential buyer or seller can be substantially
reduced. Another reason for lower search costs is the possibility to fall back on
information about past offers not executed in earlier trades or to combine searches
for several similar clients. In either case, the marginal cost of finding another
trading partner is lower than the cost of a separate search. Furthermore, since
brokers usually have a good overview of the market, they are able to judge the
quality of offers better and quicker than individual traders. In effect, they are
in the position to offer search services against fees that are smaller than the
cost of an individual search. Nevertheless, one can expect brokers to
1.2 Sources of Liquidity

57

occur in direct markets only if the scale of trading is large enough to ensure
sufficient profits. A special form of market organization, which can be classified
as a subtype of brokered markets, is an auction, i.e., a system provided by an
auction house in which an item is sold to the individual placing the highest bid
within a certain time horizon.71 The classical "English" auction is conducted as an
open bidding in which subsequent bidders know the previous bids and can react to
them. As soon as no higher bid arrives, the item is "hammered down" at the last bid
provided it exceeds the sellers "reserve price". A different possibility is a
closed auction in which bids are supplied within a given time period and remain
secret until opening. There are also further variations of auctions, with different
rules, which mainly aim at the maximal utilization of buyers' rent, i.e., at
achieving possibly highest prices. Auction systems are mainly applied for
commodities, arts, and other real goods, but they are also used on financial
markets e.g., the allocation of treasure bills is done through an auction in some
countries. The function of dealers in dealer markets is generally similar to that
of brokers they facilitate the search of individual investors for trading
partners. However, instead of only intermediating between sellers and buyers, they
trade on their own account. They are ready to purchase assets from willing sellers
and to sell them to willing buyers at any time at predetermined prices. The costs
and risks associated with this readiness to trade are covered by the difference
(spread) between the higher selling price (bid) and the lower buying price (ask).
They include, in particular, the costs and risks of finding counterparties to close
open positions as well as potential losses resulting from trading with better
informed investors.72 The existence of dealers gives investors the ability to trade
instantly at any time. The duration of search can be reduces to zero provided the
quoted bid or ask price is accepted. Thus, dealers, and even more so market makers,
who oblige themselves to quote prices on demand and trade at any time with any
investor, "bridge the time gaps between asynchronously arriving public purchases
and sales"73. They provide markets with liquidity services, the price for which is
paid through the spread. Of course, an individual investor may always seek and
possibly
71

72 73

See McAfee/McMillan (1987) or Klemperer (1999) for excellent reviews of auction


forms and theory as well as for literature references. Determinants of the bid-ask
spread are discussed more thoroughly in section 3.1.1.1. Garbade (1982), p. 429.
See also Garman (1976), p. 258.
58

Chapter 1: The Concept of Liquidity

find a trading partner offering better conditions, but they will never accept
prices worse than those quoted by dealers. In this sense, the "official" bid-ask
quotations constitute the natural boundaries for price building in dealer markets.
Although there is no compulsion for all dealers to quote precisely the same prices,
they usually do not differ substantially. Competition and the ease of obtaining
quotes from several parties should effectively direct investors to those offering
lowest possible spreads. In practice, differences between quotes are marginal,
especially in more lively markets. A standard auction, as described earlier in this
section, despite the similar name, has only little in common with an auction
trading system, which is the main form of organization of security markets. The
term "auction market" refers to a number of different forms of trading,74 all of
which have one common feature buyers and sellers are paired directly, without an
intermediary, through an organized trading system. Interested parties place their
orders with the exchange specifying desired quantities. Two types of orders are
usually allowed: limit orders, in which a price limit is set, and market orders,
which are executed at any price.75 After collecting all orders, a single price is
set, which applies to all transactions.76 The resulting market price is the one at
which demand and supply are in equilibrium; simultaneously, this is the price that
leads to the maximal trading volume.77 This means that only sell limit orders below
the market price and buy limit orders above the market price as well as market
orders are executed. Depending on the frequency of order execution, two types of
auction markets can be differentiated. On discrete (periodic) markets, transactions
are executed in fixed time intervals between which orders are collected. In
continuous markets, orders are executed as they arrive provided sufficient
counterorders are available. Execution times of transactions should be typically
shorter in the latter ones.
74 75

76

77

See Benesch/Prggler (2005) for an international review of stock markets'


organizations. See Francis/Ibbotson (2002), p. 131 ff., Fabozzi/Modigliani (2003),
p. 254 ff., or Bodie et al. (2005), p. 78 ff. Two further often distinguished types
of orders are stop orders and stop-limit orders, which are executed as market or
limit orders, respectively, only if the market price reaches a predetermined stop
price. The mechanisms of "order collecting" vary from one market to another and are
sometimes highly complex. Individuals are usually allowed to place their orders
through a brokerage house only. Furthermore, specialists exist in most stock
exchanges overseeing the order flow process and, to some extent, steering it by
buying and selling on their own account. The details of stock exchange trading
systems are, however, not crucial for the analysis in this book, so the reader is
referred to the extensive literature on the subject. See, e.g., Garbade (1982),
Chapter 22, or Fabozzi/Modigliani (2003), Chapter 13. See Schmidt (1988), p. 11-12,
for an example on how stock exchange market prices are set.
1.2 Sources of Liquidity

59

1.2.3.2. Market Organization, Search, and Liquidity


The form of market organization plays a big role not only for the time necessary to
buy or to sell an asset but also for the price level. Obviously, it affects the
price-time locus of liquidation and the certainty about its shape, the constructs
on which the concept of liquidity used in this work is based. The dependence
between the way an asset is traded and its liquidity is discussed in the following.
There is substantial literature on the role of market organization (trading
mechanism) for different aspects of market functioning, mainly in the area of
market microstructure. It concentrates predominantly on the characteristics of
returns under different regimes;78 some of it, however, also refers to liquidity.
Among the latter are such significant papers as Garman (1976), Garbade/Silber
(1979), Grossman/Miller (1988), or Hasbrouck (1991a). However, the literature on
this subject seems to cover only dealer and auction markets; refereces to non-
organized (i.e., direct or brokered) markets are practically non-existent. As it
seems, most authors assume that the former ones always provide superior liquidity
and see no need to discuss this issue. Although this thesis surely holds in the
majority of cases, the analysis in this section shows that its validity is not as
straightforward as it may seem. Two central issues related to market organization
are the search for a trading partner and the negotiation of prices. Search means in
this context the process of obtaining information about available trading
possibilities. An investor willing to sell an asset has to identify at least one
potential buyer; identifying more than one opens the possibility of choosing the
one that offers best conditions. In this sense, search has a positive value as it
allows achieving potentially higher sale proceeds. This interpretation of search as
a process of obtaining valuable information has been introduced by Stigler (1961)
initiating research in information economies.79 Search, however, is also costly.
The magnitude of the search costs depends on a variety of factors. Firstly, the
characteristics of assets play a big role. In particular, complexity and weak
comparability of assets result in the necessity of individual assessment of the
true value of each investment, which might prove very expensive. For example, in a
real estate transaction an extensive check of the true state of the property
(building) is necessary, buying private
78

79

See Cohen et al. (1978, 1980), Amihud/Mendelson (1987), Madhavan (1992), or


Affleck-Graves et al. (1994). See also the discussion and the literature review in
section 2.1.
60

Chapter 1: The Concept of Liquidity

equity requires an in-depth analysis of the company, and selling a Picasso painting
is hardly possible without a genuineness expertise. In all these cases, the
verification of the true characteristics of the traded asset is a time and money
consuming process, so that reviewing a large number of alternatives may prove
uneconomic. Secondly, search costs depend on the intensity of trading. The more
buyers and sellers are active on a market, the easier is the identification of
possible trading partners. Finally, the cost of communication between traders plays
a big role. This is clearly visible in the age of widely available electronic
telecommunication systems. The ability of cheap communication with geographically
remote parts of the world significantly increases the range of potential trading
opportunities. The form of market organization affects the "ease of trading" by
determining the mechanism of the search process and the level of search costs. On
direct markets, investors need to search individually caring the full costs of
finding potential buyers or sellers, communicating with them, verifying the asset
etc.. Brokers can help to simplify the search process and reduce these costs by
taking advantage of economies of scale and utilizing their expertise knowledge.
However, although they take over the task of identifying potentially interesting
sale or purchase offers, the investor still needs to choose the preferred one
herself. This problem disappears to a large extent in dealer markets by offering
immediate sales and purchases, dealers assume the full risk of finding appropriate
trading partners to close their open positions. Investors' (residual) necessity of
search is, thus, reduced to finding the dealer who offers the best quote; yet, due
to the proximity of quotations, it is usually hardly remunerative. Finally, there
is neither need nor possibility of search in auction markets orders from
interested buyers and sellers are gathered in one place and paired automatically
without any additional effort. Summing up, the need to search for a trading partner
as well as the cost of conducting it diminish as one moves to "higher" forms of
market organization. Another channel through which market organization affects
liquidity is the intensity of trade. In general, better and cheaper possibilities
of marketing an asset induce a larger number of investors to trade more frequently.
So, forms of market organization providing better possibilities of finding a
trading partner at a lower cost should also lead to higher trading activity. On the
other hand, more intensive trading increases the chance of finding a trading
partner. This, in turn, leads to a further reduction of the search costs and
attracts further traders. Due to this self accelerating process, the increase in
1.2 Sources of Liquidity

61

liquidity resulting from the implementation of a more efficient trading system is


larger than the mere reduction of the search costs. However, certain levels of
trading activity need to be reached in order to enable higher forms of market
organization.80 The existence of brokers depends on the possibility of sufficient
earnings from offering this kind of services, which is only given if the number of
transactions exceeds some minimal level. Similarly, dealing activity makes only
sense when open positions can be closed relatively promptly. Otherwise dealers
would unwillingly run too high risks on suboptimal asset portfolios that could not
be covered by reasonably high spreads. Also auction markets cannot function
efficiently without a continuous flow of supply and demand; the cost of their
maintenance would not be justified with only few trades per period. Another hurdle
is the possibility of standardizating the traded assets.81 Full comparability of
all trading units is one of the main conditions for dealer and auction markets.
Without it, no unified system of price quotations or a single market price valid
for all traders is possible. The form of market organization affects not only the
duration and the cost of searching, but it can also affect the level of prices
achievable for certain assets. To this end, it is necessary to note that the term
"market value" has a different meaning under different trading regimes. In fact, a
single "market price" exists only in auction markets; there is no such concept
under other market forms. Dealer markets know at least two price levels that are
potential candidates for the market value. The mid-price is usually regarded as the
presumed single equilibrium price. However, this only holds if the demand and the
supply side of the market are perfectly symmetric; in particular, the costs of
inspection, trade execution, and delivery need to be identical for both sides. In
direct and brokered markets, no distinguished prices exits that could be
interpreted in the sense of a market value. Each transaction is negotiated
individually and results in a different price. The average transaction value may be
treated as an indicator for the unobservable "fair value". For the lack of a better
solution, this is done throughout this book, though it seems to be a highly
imperfect proxy. In particular, it might be dis-

80

81

Note, however, that trading activity should be associated with the number of
transactions rather than with the trading volume. Garbade (1982), pp. 426-427,
points out that only the combination of the volume and the average transaction size
is relevant for the feasibility of "higher" forms of market organization.
Garbade/Silber (1979) refer to the number of market participants in this context.
Garbade (1982), pp. 499, stresses the importance of the existence of close
substitutes between securities for market liquidity, which is analogical to the
role of standardization discussed here.
62

Chapter 1: The Concept of Liquidity

torted by only few unusual transactions (outliers), especially, if the overall


trading volume is low. In view of the discrepancies in the meaning of market value
and in the formation of transaction prices, it is by no means obvious that an asset
should have the same price among the same group of traders under different forms of
market organization. In particular, the maximum achievable price, which, as noted
in section 1.2.2.1, is especially relevant for liquidity analysis, can and most
probably will be different under different regimes. From the point of view of an
individual investor prices on a dealer or an auction market are set exogenously and
are not negotiable. Thus, the market price or the bid price is simultaneously the
highest possible one. In contrast, traders in nonorganized markets can negotiate
freely, so the only limit to the transaction price is the ability to find a trading
partner willing to pay it. In consequence, the achievable price level should be
regularly higher on direct or brokered markets than on dealer or auction markets.82
In terms of price-time loci, it means that while organized markets allow achieving
the market or the bid price more quickly or even immediately, nonorganized markets
may allow reaching higher liquidation values at the cost of longer liquidation
periods, as depicted in Figure 1-13. In this situation, none of the markets can be
denoted as clearly more or less liquid (in terms of marketability) and
ambiguousness analogical to the one discussed in section 1.1.1.1 and depicted in
Figure 1-2 occurs.83 Note, however, that this holds only when referring to two
parallel markets for the same asset. When two different assets with different
market organizations are considered, their price levels are not directly comparable
it makes little sense to deliberate about the hypothetical price a stock exchange
traded share would achieve if it was traded directly. In this case, it seems
reasonable to scale the prices to the respective maximally achievable levels. Doing
so would result in the price-time loci of assets traded on non-organized markets
lying below the loci of assets traded on organized markets as indicated with the
dotted line in Figure 1-13. From the investor's point of view, the latter would be
perceived as more marketable.

82

83

Note, however, that this thesis refers to the prices achievable by an individual
investor and not necessarily to the level of prices on the market. In this respect,
simulations by Morawski/Schnelle (2006) indicate that the average price level of an
asset should be higher on an auction market than on a direct market if traders
stick to their valuations, i.e., do not sell (buy) under (over) the individually
assessed values. See also the analysis in section 2.3.2.
1.2 Sources of Liquidity

63

Price

non-organized markets (unscaled)

organized markets non-organized markets (scaled to the maximum achievable price)

Time Figure 1-13: Price-time loci for organized and non-organized markets

Finally, the role of market organization and search for the level of liquidity risk
incurred by market participants needs to be highlighted. Liquidity risk has been
defined as the uncertainty about the effectively achieved transaction price or its
deviation from the market value in the moment of the decision to transact.
Obviously, the amount of liquidity risk associated with a certain investment
depends on the ability to transact quickly, which, as discussed above, is
influenced by the organization of trading. Moreover, since the transaction value is
usually the result of a search, also liquidity risk depends on the characteristics
of the search process. Because search is obsolete in organized markets, there is
only marginal uncertainly about the deviation of the transaction price from the
market value of an asset. On the other hand, search is necessary and reasonable in
non-organized markets. Its outcome depends to a large extent on the luck of finding
a "good" or a "poor" trading partner. This property makes direct and brokered
markets clearly subject to higher liquidity risk. Furthermore, if one assumes that
transactions on most of the large dealer or auction markets are executed nearly
immediately, also the chance that the level of market prices would change during
the time between the placement and the execution of an order is minimal.84 Thus,
one could consider such markets as lacking any liquidity risk. This assumption is
fairly realistic when comparing, e.g., stock exchanges with real estate markets,
and it is used
84

This holds especially for institutional investors under normal market conditions;
for smaller investors and in times of turmoils, the delay in the execution of an
order and the risk that the market price would change in the meantime may be
significantly higher.
64

Chapter 1: The Concept of Liquidity

in the formal analysis further in the book to provide a reference point for
measuring liquidity risk. Further aspects of market organization relevant for
liquidity can be named. They concern mostly the details of trading regulations. For
example, the "tick size", i.e., the minimal possible change of the market price may
play a significant role in some situations. Narrowing of the bid-ask spread has
been observed as the result of a tick reduction in several cases.85 Also the
"clearing frequency", i.e., the frequency of order execution, is potentially
relevant for liquidity.86 The latter one can be also understood more generally as
the typical time gap between the agreements to trade and the execution of a
transaction. It results, in particular, from legal regulations, which encompass the
average duration of formalities that need to be fulfilled before the ownership
change is effective and the payment is made. Thus, although the sale of shares on a
stock exchange can be accomplished within minutes, it can take up to several
working days until cash is paid. Similarly, formalities associated with the notary
act and the entry in the land register (cadastre) when selling a property may
require time. Although these and other organizational details may play an enormous
role in certain special situations, they should be less important in the "standard
case". They are therefore largely omitted in the further analysis. 1.2.4. Diversity
of Valuations

As already indicated in the preceding section, the existence of an objectively


correct price or value is a purely theoretical concept with respect to nearly any
economic good. In fact, different investors asked about the value of any asset will
give varying answers. Some of them will provide higher estimates and will be ready
to pay higher prices, while others will be more conservative in this respect.
Although varying individual valuations are in many cases results of methodical
errors, many of them are still subjectively correct. In effect, there is no unique
and objective value but rather a distribution of values among market participants.
Even though a single price exists in certain markets, it is only a derivate of the
respective value distribution; its existence is by

85

86

See MacKinnon/Nemiroff (1999) for the American Stock Exchange or Ahn et al. (2007)
for the Tokyo Stock Exchange. Garbade/Silber (1979) analyze the role of the
clearing frequency on liquidity and risk.
1.2 Sources of Liquidity

65

no means a sign of a perfect agreement among investors. This fact has significant
consequences for liquidity, which are the subject of this section.87 There are a
number of reasons, why different individuals attach different values to one and the
same asset. The three most important ones seem to be: divergence of information,
divergence of expectations, and divergence of use possibilities. The first one is
also referred to as information asymmetry and arises from different access to non
public information. Differences in the quality of possessed information result in
differences in the rationales underlying individual valuations. However, not only
the access but also the interpretation of information is relevant. Hence, different
forecasts concerning the future development of an investment can be derived by
different investors even if they are based on the same set of data. The resulting
divergence of expectations can refer to future cash flows but also to risks
associated with an investment. Note that this source of valuation diversity is
based on more or less random errors. While some tend to overestimate the future
prospects, others underestimate them coming to different values. These differences
are of subjective nature; each individual may be convinced of his or her accuracy,
but eventually only some of them will prove to have been right. Yet, there can also
be objective reasons why investors attach different values to one and the same
investment. If they have different possibilities of using the asset, it may yield
different cash flows and cause different risks to each of them. A good example of
such divergence of use possibilities is the case of an industrial property, e.g.,
an automobile assembly. While some investors, especially car producers, may be able
to use it efficiently in order to optimize their revenues, many others would hardly
be able to take advantage of the special features of that property. Also
differences in tax regulations applying to different groups of investors fall under
this category. The latter point is often the reason for different statuses of
individual and institutional or domestic and foreign investors. Another objective
reason for differences in valuations is the divergence of tastes defined as
individual utility gained from possessing an asset. A standard example is the
valuation of a Picasso painting by different individuals it varies from
"worthless" to "priceless". Different possibilities of use as well as different
tastes refer in the first place to real assets, which can be used for pro-

87

The role of investors' heterogeneity for the functioning of financial markets has
been recognized by early economists but "rediscovered" relatively recently by
authors such as Miller (1977), Williams (1977), or Mayshar (1983). Newer studies on
this subject include Miller (2001), Fama/French (2005), or Sadka/Scherbina (2006).
66

Chapter 1: The Concept of Liquidity

duction or consumption. They seem to play a smaller role with respect to financial
assets, which are treated only as sources of cash flows. However, as Fama/French
(2005) note, there is some empirical evidence that also financial investors follow
certain seemingly irrational tastes. For example, they tend to invest more in
domestic stocks (home bias) or in own employer's stocks than it would be justified
by the risk-return characteristics.88 Also the tendency to "socially responsible
investing", i.e., the refusal of investing in companies, which activities are
considered immoral or socially unwelcome, 89 can be defined as "taste". A number of
market microstructure researchers have studied the effects of asymmetric
information on certain aspects of market liquidity, mainly market breadth and maket
depth. The main focus of these studies is on the consequences of insider activity,
i.e., the activity of individuals possesing superior information and attempting to
take advantage of it by selling fundamentally overpriced and buying fundamentally
underpriced securities. Such frameworks have been modeled in the seminal papers by
Glosten/Milgrom (1985) and Kyle (1985) as well as in numerous successive studies.90
These models formalize the intuition of Bagehot (1971) and demonstrate how market
makers need to compensate for the possibility of insider trading by widening the
quoted bid-ask spread to include the expected losses from such trades. Furthermore,
market makers also react to the order flow assuming the possibility that it is
information motivated. These reactions result in the impact of trading on the
spread, which should be stronger when more informed individuals are expected to be
active in the market and weaker when more uninformed, "noisy" investors are active.
The possibility of insider trading and the reactions of market makers make
strategic behavior of market participants worthwhile. On the one hand, investors
possessing valuable private information choose trading patterns allowing them to
maximize their profits; on the other hand, uninformed investors try to trade in a
way that exposes them as little as possible to price reactions evoked by
insiders.91 Such strategies are based mainly on the timing of orders, what may lead
to fluctuations of the trading volume over time. Summing up, larger information
asymmetry among market participants leads to larger
88 89

90 91

See French/Poterba (1991) or Cohen (2006). See http://www.socialinvest.org or


http://www.domini.com for reviews of "socially responsible" investment
alternatives. See O'Hara (1997), Chapters 4 and 5, for an excellent review of
research in this direction. See Kyle (1985) or Back (1992) for models of strategic
behavior of insiders and Admati/Pfleiderer (1988) or Foster/Viswanathan (1990) for
model of strategic behavior of uninformed traders.
1.2 Sources of Liquidity

67

market breadth as both buyers and seller must take into account the possibility
that the trading partner is better informed. It also leads to larger market impacts
of trading as it is more probable that larger trades are based on insider
information. Finally, it may lead to a reduced trading volume in some periods as
uninformed traders postpone their orders in order to avoid being mistaken for
informed ones. The latter point makes it clear how investor's ability to signal
that she does not have superior information may influence the liquidity of her
assets. As soon as the dealer is sure that the trade is not information motivated,
he might be willing to tighten the spread and offer better conditions.92 The above
considerations stemming from the market microstructure analysis of organized public
markets are more difficult to apply when private markets for heterogeneous assets
are regarded. Also the nature of information asymmetry is slightly different there
while it refers to non-public information about a public company in the former
case, it occurs mostly in the relation of the current owner and a potential buyer
of the private asset in the latter case. The position of the buyer is regularly
weaker in this situation as she buys more or less the proverbial "pig in the poke".
Nevertheless, the asymmetry can be overcome by a professional valuation. Such
appraisal services are offered (and demanded) in most private markets (real estate,
arts, automobiles etc.); also the due diligence process in private equity
transactions falls under this category. Although expensive, they allow reducing or
even eliminating the differences in the information levels between buyers and
sellers in a way that is practically unavailable in public markets. Thus,
information asymmetry in private markets can be quantified as appraisal costs
making it, in consequence, similar to direct transaction costs. The liquidity
effect of information asymmetry is based on the fact that some investors know the
correct value of the asset more precisely than the others, what makes the others
fear that the informational edge could be used to their disadvantage. However, in
the case of diversity of expectations, use possibilities, or tastes no one really
knows the objective true value. The differences in valuations arise either from
errors though it is not possible to tell ex ante who is wrong and who is right
or from differences in individual utilities. These sources of investors'
heterogeneity are exogenous and can92

The role of investor's reputation for the level of indirect trading costs has been
highlighted by Keim/Madhavan (1998). Due to the close relation between the indirect
transaction costs and liquidity see section 1.2.2.2 for a discussion the
importance of reputation for the individually experienced level of liquidity can be
derived per analogy.
68

Chapter 1: The Concept of Liquidity

not be easily removed by providing better access to information. They result in a


distribution of valuations among investors, which can be supposed to concentrate
around the (however defined) fair value; however, a unique and objective "true
value" does not exist. In this sense, heterogeneity of valuations exists in both
organized and nonorganized markets, although it is obscured by the existence of
central price setting systems in the former ones. In order to clarify how the
heterogeneity of investors' valuations affects liquidity, it is useful to consider
its effects on the buyers' and sellers' side of the market separately. It seems
rational to assume that the valuations' distribution of potential buyers lies more
to the left than the respective distribution of the sellers' valuations.93 This
assumption is intuitive since potential seller are the actual holders of the
assets, they should on average assign them higher values or they wouldn't hold them
otherwise. Such presentation of the market situation allows several convenient
interpretations. On the one hand, the distance between the distributions, measured,
for example, as the difference between the means or medians, corresponds with the
"distance" between the supply and the demand side of the market and can be
interpreted as market breadth. On the other hand, the intersection of the two
distributions determines the room in which trade agreements are possible. It is
denoted as the price building room and corresponds with the shaded areas in Figure
1-14. A larger area indicates a larger number of possible buyer-seller pairs and,
thus, a larger number of possible transactions. In this sense, it corresponds with
market depth. Hence, larger price building room in the intersection of valuations'
distributions indicates higher expected liquidity of the market and better
marketability of the respective asset.94 The price building room indicates only the
potentially possible transactions. The number of transactions that indeed occur
depends, however, largely on the way trade is organized. On non-organized (direct
or brokered) markets in which buyers and sellers

93

94

See Geltner (1997), p. 424, or Fisher et al. (2003), p. 273. Note, however, that
with the possibility of short sales every individual can be considered as a
potential buyer and seller at the same time, so that both sides of the market stem
from one and the same distribution of valuations among all market participants in
this case. These and the following considerations are based on Fisher et al.
(2003), pp. 275 f., especially FN 8. Note, however, that Fisher et al. refer to the
distribution of reservation prices rather than valuations. This implies strategic
behavior of market participants searching for trading partners and seems, in fact,
more realistic. For better tractability this issue is omitted here and returned to
in more detail in the next Chapter in section 2.4.
1.2 Sources of Liquidity

69

seek each other and agree on prices individually, it is theoretically possible that
all buyers and sellers in the price building room transact if they match themselves
perfectly; however, it is also possible that with "bad luck" only few of them find
a suitable partner. The actual result depends largely on the applied means of
search, such as a specialized communication system or the assistance of a broker,
and will most probably vary from one period to another. Similarly, the scope of
realized transaction prices is varying in non-organized markets, so that individual
traders cannot be certain about the eventually paid or received prices. Both of
these sources of uncertainty about the ability to transact and about the final
execution price are related to liquidity risk (see section 1.1.2). On the other
hand, organized trading systems determine a single execution price, which is either
different for buyers and sellers (dealer markets) or identical for both sides of
the market (auction markets). This means that only a part of the potentially
possible transactions is actually executed only the buyers "left" to the single
price and the sellers "right" to the single price are comforted. There is, however,
less uncertainty about the number of transactions and about the prices. Comparing
the two main types of market organization leads to the conclusion that organized
markets trade the manifold possibilities of transacting arising from investors'
heterogeneity against the certainty of trading. In other words, auction markets
offer lower liquidity risk than direct markets, but they also reduce the potential
for trading agreements.95 Association of liquidity with the area of the price
building room allows a relatively straightforward analysis of the effects of
changes in the traders' valuation heterogeneity on the liquidity of privately
traded assets. Consider the case in which the diversity of opinions or tastes
suddenly decreases, but all other market parameters remain constant. In the sense
of valuations' distributions this would mean a narrowing of the respective sellers
and buyers distribution curves this situation is depicted in Figure 114 in charts
a) and b). One of the effects is the reduction of the intersection area indicating
a smaller number of potentially possible transactions. With less dispersion in
investors' valuations, there are fewer buyers ready to pay higher prices and fewer
sel-

95

This conclusion has been confirmed in a simulation study by Morawski/Schnelle


(2006). The authors set up a finite number of investors with heterogeneous beliefs
about the true value of an asset, who are making random decisions to trade. They
examine two different trading systems: a direct market, in which traders are
allowed to review one random trading partner per period, and an auction market, in
which a single price is set on the basis of (limit) buy and sell orders. The
results of multiple simulations indicated higher trading volumes as well as higher
variability of transaction prices on the direct market.
70

Chapter 1: The Concept of Liquidity

lers ready to accept lower prices, so that it becomes more difficult for two
individuals who could theoretically agree on a common transaction price to actually
meet each other. In effect, the expected ease of liquidation and the marketability
of the assets traded on this market decrease. However, also the dispersion of
transaction prices is lower. It is therefore possible that those investors who
would be able to trade in the new situation would be facing lower uncertainty about
the outcome of the liquidation, i.e., lower liquidity risk. Thus, the overall
liquidity effect is unclear.
1.2 Sources of Liquidity

71

a) Frequency

Buyers

Sellers

Price building room

Valuation

b) Frequency Buyers Sellers

Price building room

Valuation

c) Frequency Buyers Sellers

Price building room

Valuation

Figure 1-14: Diversity of valuations and the price building room


72

Chapter 1: The Concept of Liquidity

The above considerations were based on the assumption that market parameters other
than valuation diversity remain unchanged. Yet, in the real world, sellers and
buyers cannot be seen as fully separate groups. In fact, it is probable that lower
dispersion of valuations would not only affect the shapes of the buyers' and
sellers' distributions but also bring them nearer to each other as demonstrated in
the charts b) and c) in Figure 1-14. This, in turn, would result in lower market
breadth, larger price building room and, consequently, in a larger number of
possible transactions. In total, it is possible that despite the decrease in the
heterogeneity of market participants' valuations the size of the price building
area remains unchanged as in the charts a) and c). Still, the levels of liquidity
in these two cases (i.e., high diversity of valuations combined with large market
breadth versus low diversity of valuations combined with small market breadth) are
not identical. Although the number of possible transactions is the same, the
dispersion of possible prices is smaller in the second case. This means that an
individual trader is less uncertain about the final transaction price achieved in
the sale of her asset, i.e., she is exposed to lower liquidity risk. Thus, despite
the same level of asset's perceived marketability, its liquidity is higher in the
case depicted in the chart c) than in the case depicted in the chart a).96 The
final conclusion from the above considerations is the non-trivial character of the
relation between the diversity of valuations and liquidity. It can depend on a
number of factors, such as the form of market organization or market breadth.
Moreover, the ambiguousness of the liquidity effect can be even larger when
possible changes in the shapes of the distributions, which may be the result of,
e.g., some sellers changing their minds and becoming buyers or vice versa, are
considered. Still, it is one of the crucial issues in modeling liquidity and will
be addressed on several occasions in the later chapters.

96

An interesting side effect of presenting different market states in form of


distributions of buyers' and sellers' valuations is the demonstration of the
relation between market breadth and market depth discussed in section 1.1.1.2. It
follows from the analysis of Figure 1-14 that lower breadth (i.e., a smaller
distance between the buyers' and the sellers' distribution) results in larger depth
denoted as the intersection area of the distributions. However, the same does not
necessarily hold in the opposite direction, i.e., larger depth is not necessarily a
result of lower breadth but may also be caused by larger diversity of valuations
among market participants.
1.3 Review of Illiquid Assets

73

1.3.

Review of Illiquid Assets

Having formulated the definition of liquidity and analyzed its main sources, it is
now necessary to clarify which assets or asset classes are affected by this
problem. While there seems to be common agreement about which investments are to be
considered as illiquid, it is based mainly on intuition or practical experience.
Concrete features of these markets that lead to their low grade of liquidity are
relatively rarely a subject of comprehensive discussions. Thus, one goal of this
section is to provide a theoretical rationale for the existing intuitive
classification. An even more important reason for reviewing illiquid assets is the
preparation of the grounds for the application of the search theoretical approach,
which constitutes the core of this work. Although the idea behind this model,
presented in Chapter 2, is very general, its specification, which is necessary for
a practical application, must be based on properties of concrete assets. Therefore,
it is necessary to explicitly identify their key features. While it is difficult to
draw a line delimiting liquid assets form illiquid ones, it is relatively easy to
name those that are clearly highly illiquid. This section focuses on the latter
ones only. This means that security markets are omitted at this point. Of course,
to investors who trade mainly on stock exchanges some stocks (e.g., "small caps")
are clearly less liquid than other stocks (e.g., "blue chips"). Also certain
exchanges can be considered less liquid than others. Nevertheless, in each of these
cases, low liquidity is still incomparably higher than the liquidity of most direct
investments. Since the focus of the analysis in this book is on higher levels of
illiquidity, the exclusion of security markets seems justified. Before reviewing
concrete illiquid assets, general characteristics of markets, which at least
potentially can be suspected of high illiquidity, are discussed. They are derived
on the basis of considerations from the former section. The presentation of the
most prominent examples of illiquid assets follows. In the first place, real estate
investments are considered. This doubtlessly most significant illiquid asset
remains in the main focus of the analysis. The second broad category is composed of
privately traded company shares, i.e., private equity. Finally, a number of
alternative real investments are considered, among them arts, collectibles, and
wine; they receive increased attention as financial investments in the recent
years.
74 1.3.1. Characteristics of Illiquid Assets

Chapter 1: The Concept of Liquidity

The previous section provided a catalogue of sources that can lead to the lack or
at least a reduction of liquidity. Among the most important ones were direct
transaction costs, timing costs, market organization, and valuations' diversity.97
Additionally, all other effects should be allowed for as soon as they significantly
affect times and prices at which transactions are accomplished. On the basis of
these sources of liquidity, it should be possible to draw an outline of the
characteristics of an illiquid asset. The first straightforward characteristic
refers to the level of transaction costs. Clearly, this element is negatively
related to liquidity mainly because it negatively affects the benefits from
frequent trading and discourages investors from providing market depth. Thus,
investments that require the payment of high commissions or are subject to
overaverage taxation can be expected to be less liquid. Note that this criterion
applies to assets (asset classes) as well as to markets on which different assets
are traded. In particular, it can refer to national markets meaning that countries
with higher tax rates should, ceteris paribus, be less "liquid" than low-tax
countries. Timing costs refer mainly to the possibility of a change in the market
situation during the time between the decision to trade and the execution of the
transaction. Hence, assets with high price volatility should also tend to be less
liquid. However, not the absolute but much more the relative volatility compared to
the frequency of trading possibilities is to be considered at this point. Clearly,
if an asset X can be traded only once a day and an asset Y can be bought or sold
every minute, given the same level of daily volatility, the first one is associated
with much higher timing costs. Thus, only the volatility between subsequent trading
occasions is relevant; in the above example it is higher for the asset X. This
explains why some highly volatile assets can still be considered highly liquid
the volatility measured between subsequent transactions, which can occur even many
times a second, is relatively low. To sum up, illiquid assets are to be sought
among those having high price volatility on the one hand and being traded only
infrequently on the other hand.

97

Note that the indirect transaction costs, such as the bid-ask spread or the market
impact, are not regarded here, although, as discussed in section 1.2.2.2, there
will be a strong correlation between these costs and liquidity. Nevertheless, they
have been identified as results rather than causes of illiquidity and as such do
not make an asset or a market illiquid.
1.3 Review of Illiquid Assets

75

A further characteristic of potentially illiquid assets or markets can be derived


from the form of market organization. Generally, liquidity should be higher when it
is easier for market participants to trade. This implies the superiority of those
forms of trading under which market entry barriers are lowest. The review of
different forms of market organization in section 1.2.3.1 led to the conclusion
that organized public markets should be generally more efficient in bringing buyers
and sellers together and, thus, more liquid. On the other pole are direct markets
with each investor searching for a trading partner on her own the overall
difficulty in finding a trading partner should be higher there indicating lower
liquidity. Hence, one would expect privately traded assets to be less liquid.
However, one should not overlook the fact that a direct market can offer the
possibility of achieving better prices than an organized exchange with a single
market price. The superiority of organized markets with respect to their liquidity
is therefore only conditional they allow achieving the maximum achievable price
quickly and with low uncertainty (liquidity risk), but they do it at the cost of
giving up the chance of achieving above-average prices. Nevertheless, in practice,
the majority of markets regarded by investors as illiquid are private. When
considering the form of market organization as a criterion for the identification
of illiquid markets, one should bear in mind that it is not a purely endogenous
feature and that it arises from the characteristics of the asset in question. Most
important seem the comparability of items within the asset class and the ease of
ownership transfer. On the one hand, highly homogenous assets are easy to
standardize, what makes the organization of wide and anonymous trading systems
possible. On the other hand, heterogeneous and hardly comparable assets enforce
non-organized trading systems as there is no easy way of a quick and effective
assessment of their true values. Same logic, though with lower severity, applies
with respect to legal regulations the more difficult an ownership change is, the
less probable is the development of an organized trading system. Thus,
heterogeneous assets with highly regulated transaction procedures are natural
candidates for illiquid investments. Finally, the divergence of asset's valuations
among investors has proven to be relevant for liquidity, but the direction of the
effect was not clear. Given constant market breadth, more heterogeneity among
buyers and sellers increases trading possibilities, but given a constant price
building room, i.e., a constant number of potentially possible trades, lower
divergence of valuations improves liquidity. As already noted in sec-
76

Chapter 1: The Concept of Liquidity

tion 1.2.4, the second scenario seems to be more probable in reality. Since buyers
and sellers are not really two distinctly separate groups, it seems more likely
that a change in the overall investor heterogeneity would affect both sides of the
market simultaneously moving the valuations' distributions closer together (see
Figure 1-14). In this case, markets with less heterogeneous investors should also
tend to be more liquid.98 The indicators formulated above should provide the first
hints of possible illiquidity of assets or markets. However, they are by no means
definite evidence of this quality. Therefore, only those asset types are discussed
in the following subsections with respect to which illiquidity indications are
especially strong. These are: direct property investments, private equity, and a
broad class of alternative investments. They all seem to fit perfectly in the
scheme presented here. 1.3.2. Real Estate

Although it seems intuitively clear what real estate is, there are at least several
approaches to defining it. Probably the most famous definition is the economic one
provided by Graaskamp (1972, p. 513) and characterizing real estate as "a
manufactured product of artificially differentiated cubage with an institutional
time dimension designed to interface society with the natural recourse land". This
short sentence recapitulates the main dimensions of this investment: room and time.
The use of room over time generates utility, which in the investment perspective
can be measured in money units.99 Thus, a real estate market can be characterized
as a market for the usage of delimited room, while usage can also include rental.
On the other hand, the legal definition treats real estate as a bundle of rights
encompassing the right to trespass, to use, to rent, or to change (develop) it.100
These rights may be limited (e.g., by land use restrictions) and also partially
divided and distributed among individuals. These two approaches are mainly relevant
from the investment perspective. Note that the "technical" side (e.g., architecture
or technical facilities) is only of secondary relevance in this case.
98

99

100

Note at this point that although asset heterogeneity and investor heterogeneity are
two different terms, some relation between them is probable. Weaker comparability
increases the chance that investors disagree on the true characteristics of the
asset giving another reason for different valuations. Pyhrr et al. (1989), p. 4,
describes real estate in short as "money flow over time", which is, in fact,
identical with the definition of any cash flow generating financial investment. See
Ling/Archer (2005), p. 5.
1.3 Review of Illiquid Assets

77

The economic importance of real estate as a capital investment is manifested by its


high share in the total assets of national economies. Even though such estimations
are extremely difficult, and the results obtained from different sources vary
strongly, their message is clear. For example, Federal Reserve's assessments of the
share of real estate in the household wealth in the USA are between 20% and 45%;101
the analogical assessment for Germany is about 50%102. On the other hand, the
preliminary result of the Luxembourg Wealth Study a comparative analysis of
household wealth provides estimates of real estate in household portfolios (net
of house secured debt) in several countries at between ca. 40% and 70%.103
Ibbotson/Siegel (1983) assess the portion of real estate in a "world wealth
portfolio" at over 50%; also in the "world investable wealth", real estate has the
largest portion. Data on real estate holdings by institutional investors is even
less reliable. Estimates of the optimal share of this asset in a mixed-asset
portfolio by various researchers range between ca. 10% and 20%.104 These figures,
despite the lack of precision, demonstrate that real estate is doubtlessly the most
important illiquid asset, if not the most important asset at all. There is common
agreement that even the most liquid (direct) property investments are still far
less liquid than any other traditional financial asset. Exceptions are few and
occur practically only in extraordinary market situations. The analysis of the
features of various property markets confirms these observations. To start with, a
look at the transaction costs associated with real estate trading reveals that they
are, in fact, extraordinarily high. They encompass a long list of positions
including appraisal fees, brokerage commissions, legal fees, mortgage-related fees,
or transfer taxes. Precise estimates are difficult and vary strongly not only
internationally but also among different property types. Several researchers assess
the transaction costs associated with homeownership (house sale) in the USA at
between 6% and 13%.105 CMS (2005) provides an overview over real estate transaction
costs in Europe listing 13 different categories a selection is presented in Table
1-3. Although precise figures for the total costs are difficult to quote due to the
complexity of the regulations and partial negotiability of the fees, they amount to
several percent of the value in most cases. In compar101 102 103 104

105

See Ling/Archer, 2005, p. 10, and Ibbotson/Siegel (1983). See various monthly
reports of Deutsche Bundesbank. See Brandolini et al. (2006). See Fogler (1984),
Firstenberg et al. (1988), Giliberto (1992), or Kallberg et al. (1996). Webb et al.
(1988) consider an even higher real estate share in investment portfolios (up to
60%) as eligible. See references cited in Haurin/Gill (2002), pp. 564 f.
78

Chapter 1: The Concept of Liquidity

ison, direct trading costs of publicly traded equities are nearly negligible;
Domowitz et al. (2001) assessed the average explicit trading cost (commissions and
fees) for institutional investors in the USA at about 0.2% and worldwide at about
0.4%.106
Table 1-3: Elements of real estate transaction costs in selected European
countries107 Survey/Valuation Fees France Approx. 3,80014,000 Transfer Duty 5.09%
if no VAT applies (VAT applies on first sale within five years of building
completion). 3.5% of purchase price Land Registry Registration Fees Where VAT is
due, 0.615% real estate property tax applies otary Fees 0.825% of value

Germany

Survey: hourly rates starting at 38.5. Valuation fee depends on value/difficulty,


e.g., value 1m: 1,800 to 3,000 Approx. 0.2%0.4% of purchase price, depending on
nature of property

Scale fees, e.g., value 1m: 1,557

On contract, e.g. value 1m: 3,500 to 3,900. On conveyance, e.g. value 1m: 800.
Signature affirmation: 130 Scale fees (approx. 0.15%-2% of the transaction value)
according to value and title enquiries required Contract sale, e.g. value 1m: from
1,131 to 3,678. Not applicable

Italy

Depends on the status of the seller and the nature of the property: 168 if no VAT
applies, 7% of the value otherwise 6% of purchase price Up to 4% of total purchase
consideration

Depends on the status of the seller and the nature of the property: 336 if no VAT
applies, 3% of the value otherwise Maximum 455

The etherlands United Kingdom

1%-2% of purchase price 1%-2% of purchase price

Maximum 1,120 (Scotland max. 12,000)

Another liquidity related issue concerns the opportunity costs associated with real
estate investments, in particular the timing costs. As discussed earlier, they
increase with the instability of prices, which is usually measured with price or
return volatility. In the common opinion, property prices remain relatively stable
over time compared to other investments. The annual volatility of real estate
returns reported in the literature ranges from about 2% to about 9%, whereas the
volatility of returns of major stock
106

107

However, the costs for individual investors are higher as they include brokerage
fees. See Bodie et al. (2005), p. 86. Source: CMS (2005).
1.3 Review of Illiquid Assets

79

indices exceeds 20%.108 This would indicate that the timing component of the
transaction costs is relatively small in the case of real estate. However, it has
been noted in the prior discussion that not the absolute volatility but rather the
volatility between subsequent trading opportunities is relevant in this context.
Since the frequency of real estate transactions is very low in comparison to other
assets, the effective price variability between time points at which a transaction
can be accomplished may still be relatively high. To illustrate this consider a
real estate market with 5% annual volatility and a stock market with 20% annual
volatility of total returns. On the first glace, the property market seems to be
much more stable. However, assuming that transactions occur there only once a week
while stocks are traded every minute leads to a different picture. Recalculating
the volatilities in terms of the variability between subsequent transactions yields
approximately 0.7% for the real estate market (given 52 transactions a year) and
only 0.03% for the stock market (given 500,000 transactions a year). This means
that the timing cost associated with real estate is much higher than the cost
associated with listed stocks. Although the figures assumed in this example are
fictional, they are not unrealistic. So, the risk of a substantial unfavorable
price change between the moment an investor decides to sell a property and the
moment the trade is accomplished (the price agreement is met) is, in fact, far
higher than suggested by the overall real estate price variability. Also the form
of market organization predestines private real estate as a highly illiquid
inestment. It is traded on non-organized markets practically without exception. By
far most popular are brokered markets. They are typical for residential, office,
and retail properties, although both the number of brokers and the scope of
services offered differ strongly. Direct markets often function parallel, since not
all individuals are ready to bear high broker provisions; their share in the total
turnover is, however, usually smaller. On the other hand, for some less active
markets, like special properties, where the trading volume is too small for a
profitable brokerage activity, direct search is the only possibility of finding a
buyers or a seller. An alternative system, which

108

E.g.: Maurer et al. (2004) report annual volatilities of the German, American, and
British real estate at 2.34%, 5.99%, and 8.96% respectively; the annualized
volatilities of the American S&P 500, British FTSE 100, and German CDAX for the
last 10 years (1996-2006) were 21.5%, 21.5%, and 26.5%, respectively (computed on
the basis of data from Thomson Financial Datastream).
80

Chapter 1: The Concept of Liquidity

gains increasing popularity, is a property auction.109 Such auctions are organized


either as sealed bids systems the vendor sets a minimum price, invites non-public
bids and selects the buyer after all bids have been placed or as "English"
auctions with open ascending bids. This form of sale organization enables the
seller to exhaust the buyers' willingness to pay to a higher extent than it would
be possible in the traditional "search and negotiate" system.110 However, it is
also possible that the cost of organizing an auction exceed these additional gains.
Furthermore, since auctions take place only infrequently, there is no regular
trading. In effect, finding a trading partner in a real estate transaction is
practically always connected with a costly and time-consuming search. Finally, also
the heterogeneity of real estate contributes to its illiquidity resulting in higher
information costs (appraisal fees), weaker market transparency, and consequently,
higher disagreement about properties' values. The latter can arise from information
asymmetry sellers can be supposed to possess better information than buyers.
However, it may also originate from different possibilities of using a property or
from different tastes of investors. While the grade of the "fit" with
entrepreneurial goals plays a big role in the case of commercial real estate, the
notion of a "beautiful house" is highly relevant on residential markets.111 The
resulting diversity of valuations by market participants leads to the impossibility
of a precise estimation of a properties' sale values. This is reflected in
relatively high deviations of appraisals from subsequently realized prices they
often exceed 10%.112 As discussed in section 1.2.4, higher valuation diversity
among investors does not necessarily lead to lower marketability larger
disagreement may even allow achieving better prices on the individual

109

110

111

112

Real estate auctions are widespread in Scotland or Australia (see Lusht, 1996, p.
518, or Pryce/Gibb, 2006, pp. 380-382), but also gain popularity in the USA,
especially as online auctions (see Dymi, 2006). Interestingly, there is only
ambiguous empirical evidence that properties sell at higher prices in auctions than
in individual negotiations. On the one hand, Lush (1996) and Ashenfelter/Genesove
(1992) confirm this theses; on the other hand, Mayer (1998) and Ong (2006) came to
the contrary conclusion. The role of different use possibilities for the value of
real estate is reflected in the discussion about the appraisal principles, in
particular, in the differentiation of the "highest and best use" and the "existing
use" value. See, e.g., TEGoVA (2003), Standard 4, RICS (1995), PS 3, or Appraisal
Institute (2001), pp. 24 ff. and Chapter 12. Royal Institution of Chartered
Surveyors (RICS), a British association of real estate appraisers, reports average
absolute differences between valuations and sale prices of commercial properties in
the UK ranging from 6.9% to 12.4%. These figures were even higher in the past. See
RICS (2005).
1.3 Review of Illiquid Assets

81

level but increases the uncertainty about the liquidation value, i.e., liquidity
risk. It seems, therefore, that more heterogeneous real estate markets should tend
to be less liquid. The above review of the liquidity relevant characteristics of
real estate reveals that literally all aspects of this problem, which have been
identified on a purely theoretical basis in section 1.2, apply to this asset. This,
combined with the enormous role of real estate in the global economy, supports the
initial statement that it is by far the most important illiquid asset worldwide.
The lack of satisfactory methods to deal with illiquidity is surely one of the key
reasons, why real estate still remains at the margin of modern financial theories.
Therefore, the main focus of the analysis in this book is placed on this asset
class, although, as already mentioned, analogical reasoning can be applied to other
similarly illiquid investments. 1.3.3. Private Equity

Private equity (PE) represents a very wide category of investments. Generally, it


can be denoted as "investing in securities through a negotiated process"113 and
encompasses shares of non-public companies. Delimitation from a "normal" ownership
of a company is difficult. Among the key features of private equity are: focus on
companies in critical phases of development, high investment risk with no
sufficient securities, and provision of managerial assistance by the investor.114 A
number a various types of transactions fall under this heterogeneous category.
Depending on the stage in the corporate development, one differentiates between
venture capital (VC), i.e., highrisk investments in young companies with high
growth potential,115 buy-outs, i.e., acquisitions of large portions of companies
entailing control takeover,116 and special case financing, encompassing a broad
spectrum of situations ranging from the repayment of distressed debt to one-time
opportunities.117 Most frequent is, however, the classification of different types
of PE investments based on financing phases, as presented in Table 1-4. This broad
definition is followed here without going into its detailed com113 114 115

116 117

Bance (2004), p. 2. See Bader (1996), pp. 10 ff., Rudolph/Fischer (2000), pp. 49-
50, or Jesch (2004), pp. 21-23. Note that the term "Venture Capital" is sometimes
used as synonymous to "Private Equity", especially in Europe. See Rper (2004), p.
23. The frequent case of management buyouts (MBOs) also belongs to this category.
See Bance (2004), pp. 2-3, Bader (1996), pp. 7-9, or Jesch (2004), Chapter 6.
82

Chapter 1: The Concept of Liquidity

ponents. Also purchases of shares in PE or VC funds are often considered to be PE


investments. From the perspective of this book they are classified as such only as
far as they are not publicly traded.
Table 1-4: Stages of private equity investments118 Private Equity (= Venture
Capital in the "European" sense) Early Stage Seed Start-up Expansion Stage
Expansion Bridge Late Stage Buy-out

The role of PE as both a financing source and an investment opportunity is


increasing not only on the national level but also internationally. However, while
it experienced its main growth phase in the late 1990 together with the IT industry
boom, the sums invested in this form decreased after 2000 as the crises of this
branch came.119 Nonetheless, despite the significant drop, the scale of private
equity is still much larger in the USA and UK than in other countries. Even there,
however, it is far behind the share of wealth invested in real estate or in public
stocks, staying below 1% of the national GDPs.120 Still, the effective capital
invested in non-public companies is probably significantly higher since official
figures on private equity provided by various associations (e.g., NVCA or EVCA121)
are usually based on institutional investments, mainly those by private equity
funds. Though non-public equity investments are definitely considered as highly
illiquid,122 it is more difficult to specify the precise sources of their
illiquidity than in the case of other illiquid assets. The direct transaction costs
are, in fact, not significantly different than in other cases of corporate
ownership. They vary from one country to another but are seldom high. In fact, a
relatively inexpensive registration of the ownership change with the appropriate
authority is often all that is formally necessary. The main component of the
transaction costs is less apparent and is accrued during the investment selection
phase. The lack of sufficient information about the target company makes a
118

119 120 121

122

Based on Schefczyk (2000), p. 24. See Bader (1996), pp. 103 ff., Jesch (2004), pp.
79 ff., or Grunert (2006), pp. 6 ff., for detailed discussions of the stages. See
Haemming (2003), p. 69. See Baygan/Freudenberg (2000), p. 19. NVCA: National
Venture Capital Association (http://www.nvca.org); EVCA: European Venture Capital
Association (http://www.evca.com). See Bader (1996), pp. 75-77, 92-95, and 203, as
well as the literature references cited there.
1.3 Review of Illiquid Assets

83

costly and time consuming "due diligence" process necessary.123 During it, internal
enterprise data is evaluated in order to obtain sufficient information for the
assessment of the company's value. In this sense, it is similar to the role of
appraisals in real estate transactions and can be considered as a mean of
overcoming information asymmetry. This type of costs can be immense and encompasses
not only the expenditures entailed directly during the due diligence but also
timing costs, i.e., the costs associated with the risk that the market or the
corporate situation may change during the process. Due to the heterogeneity of
private equity seen as an asset class as well as the confidential character of
transactions, it is hardly possible to quantify the effective transaction costs,
but one can expect them to amount even up to several percents of the total
investment value. Also other characteristics of private equity reinforce its
reputation as an illiquid asset. Trading takes place practically only in form of
direct search markets. The players are mainly specialized PE or VC funds, but also
wealthy individuals ("business angels"), industrial corporations, and public-sector
institutions are active in this market.124 Due to the complex nature of this form
of corporate financing, there are no clear market structures as in the case of
other assets. The initial investment (purchase of shares) is usually made in a very
early stage, partially even before the actual foundation of the company. The
duration of the commitment is typically middle- to long-term; however, it varies
strongly depending on the goals of the investor and the characteristics of the
corporation.125 Returns are achieved mainly through a successful exit (sale), which
is conducted after the growth potential has been skimmed. There are several
possible exit alternatives.126 An initial public offering (IPO) is considered most
attractive, but is not as dominating as sometimes considered.127 Other options
encompass: sale to another PE investor (fund), sale to a corporate investor, sale
to the management, resale to the original owned (initiator), or, if the company
proves unsuccessful, discontinuation and bankruptcy. The heterogeneity of players
and assets results in the lack of market structures as they are known for other
assets. Transactions often occur within a relatively limited group of participants
and are structured very individually. Thus, an investor
123 124 125 126 127

On due diligence see Berens (2005) or Bing (1996). See Weitnauer (2001), pp. 8-10.
See Bader (1996), p. 14, and Weitnauer (2001), p. 7. See Schefczyk (2000), pp. 29-
31, Jesh (2004), pp. 97-109, or Vance (2005), pp. 152-154. According to Vance
(2005, p. 154), only 6.3% of the VC exists in the U.S. in 2002 were through an IPO.
Higher figures (up to over 40%) were only observed during the "dot com" bubble in
2000.
84

Chapter 1: The Concept of Liquidity

willing to include private equity of a very specific type in her portfolio may have
extreme difficulties to find an adequate opportunity. Similarly, it may be even
more difficult to sell shares of a private company, especially one that offers no
extraordinary value growth perspectives. The heterogeneity of companies, which
shares constitute the asset class "private equity", results in the heterogeneity of
opinions about the true values of these companies. It may arise from very different
sources. For example, in the case of a management buyout (MBO), the management can
be expected to have better information about the actual state of the business, so
there is information asymmetry between the board and other potential buyers. There
may also be differences with respect to use possibilities a corporate buyer can
possibly achieve synergy effects that are not available for other investors.
Finally, there is also uncertainty about the economic variables determining the
value of the enterprise. Different assessments of the future profitability of the
business lead to different valuations. Hence, also this aspect increases the
illiquidity of PE investments. To sum up, private equity is definitely one of the
most illiquid asset categories, but it is also a very heterogeneous one, so that
high differences in the grades of liquidity can be expected. A particularly
disturbing consequence of this fact is the extreme difficulty to assess the typical
values of liquidity related parameters, which are necessary for the specification
of the model formulated in the next Chapter. Application of the liquidity
measurement and management techniques developed in this book seems therefore hardly
realizable. For this reason, private equity is not regarded in further discussions.
1.3.4. Alternative Investments

This section encompasses a number of goods, which, although originally regarded as


consumption goods only, have evolved as financial investments as well.128 "Assets"
in this category encompass a variety of different items, among them various works
of art, wine, jewelry, antiques, collectibles (e.g., stamps or coins), and even
personal belonging of famous individuals. While many of these items play only a
marginal role as financial assets, some of them have gained high popularity in the
recent years. The fine arts have been considered an interesting investment for a
relatively long time already.
128

Note, that a wider meaning of the term ,,alternative investments" is often used,
which includes also private equity, hedge funds, commodities, and other non-
standard financial assets.
1.3 Review of Illiquid Assets

85

Cases of paintings reaching astronomical prices in auctions are reported regularly


in the press,129 but more thorough studies based on appropriate indices do not
confirm that art would offer particularly attractive risk-adjusted returns.130 Also
wine is often discussed in terms of financial investments.131 Several researchers
stated that adding this "liquid" asset to the traditional security portfolio may
allow reaching higher efficiency frontiers, i.e., achieving higher returns at lower
risks.132 The sizes of the markets for various types of alternative investments are
extremely difficult to assess. Publicly available data is limited practically only
to figures published by the leading agents, so it surely underestimates the true
volumes. There is also a practical difficulty of delimiting investments from
consumption motivated purchases. Nevertheless, the share of global wealth invested
this way is most probably diminishingly small; it might be somewhat higher only
with respect to wealthy individuals, the so called HNWIs (High Net Wealth
Individuals), who are the main players on these markets.133 The level of liquidity
of alternative assets is determined mainly by the form of trading. Probably the
most prominent one is an auction. Famous houses, such as Sotheby's or Christies,
organize auctions on a variety of collectibles including all kinds of arts,
jewelry, motor cars, or even teddy bears.134 This form of trading allows a
relatively effortless liquidation of such assets, usually at a good price and with
little uncertainty values predicted by the auctioneers deviate rarely strongly
from the actually achieved ones.135 However, auctions have also a number of
drawbacks. Firstly, they are available practically only to sellers. Buyers have no
guarantee that they will be able to purchase the chosen item at a reasonable price
and may suffer from the "winner's curse" if they attempt to precipitate the
purchase a winner willing to buy quickly may often
129 130

131 132 133

134 135

See http://www.artcult.com for examples of prices reached by various collectibles.


Although investments in arts (paintings) brought in the last century significantly
higher returns compared to other financial assets, also their return volatility was
much higher; see Anderson (1974), Stein (1977), Bryan (1985), Baumol (1986), or
Goetzmann (1993). Interestingly, most researchers state high correlations of
paintings' returns with returns on other financial assets, especially stocks. See
Wilkinson (2004), Laschinger (2004), or May (2006). See Kumar (2004) and
Engelskirchen (2006). According to CapGemini/Merrill Lynch (2006) about 20% of the
HNWIs' wealth was invested in alternative assets in 2005, and the portion is still
rising. This figure includes, however, structured products, hedge funds, managed
funds, foreign currency, commodities, and private equity. See
http://www.christies.com. See Ashenfelter (1989) for the study of auctioneers'
price prediction quality (pp. 33-35) as well as certain aspects of wine auctions'
functioning.
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Chapter 1: The Concept of Liquidity

find himself having paid too much.136 Another problem with auctions lies in the
extremely high transaction costs. At Christies, for example, buyers' premium (i.e.,
the amount that is due in addition to the "hammer price") is 20%; charges on the
seller's side depend on the client's activity during the year, but usually amount
to several percents and include insurance and shipping.137 Hence, the total cost
may be as high as one third of the actual value. Smaller houses may offer better
conditions than the big ones, but the overall cost is still high. Finally, an
auction is not necessarily a quick way of selling. At Christies, it takes about two
to three months to schedule an auction and approximately 35 days until the payment
is made thereafter. Furthermore, auctions for certain items are conducted only
infrequently. Even wine, which is comparatively popular, is offered at only about
300 auctions per year worldwide.138 Thus, depending on the type of the alternative
asset, it may take several months or longer to liquidate it. An alternative way to
buy or sell an alternative investment is by addressing a specialized dealer or by
performing ones' own search for a trading partner. The former solution may be the
quickest one. In fact, there are numerous individuals and institutions specialized
in trading various items the number of art dealers is assessed at about 9,500
compared to only about 750 auction houses.139 One can expect that a sale or a
purchase can be completed nearly immediately this way; however, since dealers often
buy and sell at auctions themselves, their selling prices will usually be higher
and purchasing prices lower than the auction prices.140 On the other hand,
searching for a buyer or seller on one's own account may yield more favorable
prices but induce high search costs. Apart from the necessity to advertise in
specialized press, the mere contact with potential trading partners scattered
throughout the world may prove costly. The thinness of the markets for particular
assets may eventually result in extremely long marketing durations.141 The fact
that a lot of trading is within relatively small
136

137 138 139 140

141

The issue of the ,,winner's curse" is, in fact, a much more general phenomenon
referring to different fields of economics. Its consequences and the conditions
under which it may occur have been intensively discussed in the literature. For
reviews of this subject and for further references see Thaler (1992), Chapter 5,
Varian (2003), Chapter 17, or Kagel/Levin (2002). See http://www.christies.com and
Burton/Jacobsen (2001), pp. 348-349. See Burton/Jacobson (2001), p. 339. See
Prickett (2004), p. 25. Anderson (1974), p. 13, estimates the mark-up of the
dealers' asking or bidding prices at as much as about 20% to 50% above or below the
auction prices. For example, an average wine auction is attended by about 100 to
150 buyers bidding on bottles offered by about 30 to 40 sellers. Given the small
number of auctions (about 300 per year world-
1.3 Review of Illiquid Assets

87

groups of specialized collectors may also make it very difficult to enter the
market as an outsider. As discussed above, none of the trading forms available for
alternative assets contributes to improving their liquidity. On the one hand, they
are associated either with long marketing durations or with significant discounts
(premiums) on the sale (purchasing) prices. On the other hand, high transaction
costs need to be accrued forcing potential investors to long holding periods and
diminishing the trading intensity on the affected markets. The catalogue of
liquidity reducing factors is even longer. In addition to the already discussed
direct trading costs, expertise expenses need to be borne; they include, e.g.,
examining the genuineness of a painting or opening some of the wine bottles for
tasting. Long liquidation periods may induce high opportunity costs; timing costs,
however, seem to be rather insignificant in this case. Finally, the extremely high
diversity of valuations also contributes to low liquidity, mainly in the sense of
higher liquidity risk. The uncertainty about the outcome of an auction is immanent
to this form of trading and is also significant in the individual search. It can be
reduced by resorting to a dealer but only at the cost of an inferior price.
Moreover, the diversity of valuations has also a very specific character. Unlike in
the case of real estate or private equity, it is mainly the divergence of tastes
that leads to different valuations of collectibles among market participants. As
such, it cannot be effectively reduced by better information of more transparent
market organization. Furthermore, as noted by Baumol (1986), the prices of works of
art and similar items are "unnatural" in the sense that they cannot be derived from
any objective notion of value based on the means of use or future cash flows. In
effect, they may have no natural equilibrium levels. The "aimless floating" of such
prices, resulting from randomly changing tastes and trends, leads to the
instability of the characteristics of these markets. Similarly as in the case of
private equity, the heterogeneity of alternative investments makes it difficult to
estimate market parameters necessary for the practical application of formal
models. The problems are amplified by the extreme thinness and the fundamental lack
of transparency of these markets as well as distortions in the price building
caused by varying tastes (fashions) or consumption oriented trading. For these
reasons,
wide), these figures give the impression how thin the global wine market actually
is (see Burton/Jacobson, 2001, p. 339). The markets for other, less popular items
are even thinner.
88

Chapter 1: The Concept of Liquidity

the application of quantitative methods, like those based on the search theoretical
approach discussed in the subsequent chapters, though theoretically possible, is
extremely difficult. Hence, also this group of illiquid assets is not further
followed here.

1.4.

Economic Relevance of Liquidity

The question addressed in this final section of the first, introductory Chapter
could very well have been asked at the very beginning: What role does liquidity
play in the economy and why should investors give it special attention? So far, the
importance of the issue was treated as given. The hitherto considerations were
based on the assumption that liquidity is relevant for investment decisions and
that more liquidity is better than less. These statements are, however, not self-
evident and require a more thorough examination. Although the scope of this section
is not sufficient to provide an extensive answer, it attempts to outline the key
aspects. The discussion starts at the very origin of liquidity, at the role of
money. This question has been addressed by countless researchers for more than a
century. The most widespread approach can, however, be traced back to Keynes and
his notion of liquidity preference. Basing on it, the significance of liquidity for
a single individual in her everyday life as well as for an investor in her capital
allocation decisions can be derived. Since the focus of this work is mainly on
investment analysis, liquidity in the context of investment goals receives special
attention. 1.4.1. Money and Liquidity Preference

Since money is the only perfectly liquid asset, any discussion about the role of
liquidity must start with the question about the role of money in the economy. Its
definition has already been provided in section 1.1.1.1 showing that the term it
not as unambiguous as it may seem. Based on the broad understanding of money, its
three functions are usually identified in the literature depending on whether it is
treated as a mean of exchange, store of value, or a unit of account.142 In the
first case, it is thought of as a vehicle through which exchange of goods and
services becomes possible without the necessity of perfect equivalence of their
values in each transaction. In comparison with a pure barter economy, using money
increases trading efficiency by reducing the effort and time that would otherwise
be necessary in order to accomplish the exchange of
142

See Borchert (1998), pp. 21 ff., Burda/Wyplosz (2005), pp. 174 ff., Howells/Bain
(2005), pp.228 ff., Mishkin (2006), pp. 45 ff., or Mankiw (2007), pp. 77 ff.
1.4 Economic Relevance of Liquidity

89

goods.143 Treating money as an asset implies that it can be used to store value.
Since its nominal value remains constant over time, it is unaffected by changes of
economic variables such as risk premiums or interest rates. However, in how far
money can be used to transfer purchasing power into future periods depends on the
stability of prices. Inflation reduces its value and deflation increases it.
Finally, money is used as a unit of account to measure values of commodities and
services. Comparability of different goods in the economy can be improved this way
leading to lower information costs and easier organization of trade. The first of
these functions, i.e., the mean of exchange, is usually seen as the primary one
distinguishing money from other financial instruments; the other two are considered
to be secondary.144 Indeed, application of alternative units for value measurement
is conceivable, and the use of money for storing wealth, especially over longer
periods of time, plays only a marginal role in the economy. Thus, the main reason
why people wish to hold money is for the sake of using it for payments. Going
deeper into the matter, one can ask about the motives that drive individuals to
hold certain amounts of money. This issue is discussed thoroughly by Keynes in his
probably most famous work "The General Theory of Employment, Interest and
Money".145 He states that the only reason for the willingness to hold money instead
of other return generating assets is the fear of the uncertain future. In their
struggle for the accumulation of wealth, individuals are aware that the
consequences of their acts are uncertain. Keeping a part of the personal wealth in
form of money allows them to react to unexpected developments more flexibly and,
thus, to face the future with more confidence. In effect, "our desire to hold money
as a store of wealth is a barometer of the degree of our distrust of our own
calculations and conventions concerning the future."146 Preference towards
liquidity is, thus, the result of uncertainty.147 While trying
143

144

145

146 147

See Brunner/Meltzer (1971), Alchian (1977), and Clower (1977) for in-deep
discussions of advantages of using money as a mean of exchange. This conclusion,
expressed in many textbooks (see the references in FN 142), was backed with a
formal analysis by Marschak (1950). However, Sawyer (2003) points out that a
different function may prove to be central depending on the assumed definition of
money. See Keynes (1936), in particular Chapters 13 and 15. For extensive comments
see Patinkin (1976) or Maclachlan (1993). Keynes (1937), p. 216. This conclusion
has been stated and restated by numerous later authors; see Jones/Ostroy (1984),
Miller (1986), or Rochon (2003) and the literature cited there. Brunner/Meltzer
(1971) discuss additionally the advantages of using money under incomplete
information.
90

Chapter 1: The Concept of Liquidity

to cope with it, individuals follow various motives, which can be classified into
three groups: the transaction motive, the precautionary motive, and the speculative
motive.148 The first one corresponds with the general need for money to conduct
day-today purchases of goods and services. Depending on whether it refers to a
private individual needing to bridge the interval between the receipt of income and
its expenditure or to a company needing to bridge the interval between the moment
costs are incurred and the moment products are sold, it can be further classified
as the income motive or the business motive, correspondingly. The precautionary
motive arises from the desire to be prepared for unexpected future expenditures
caused by unforeseen events. Finally, the speculative motive is based on the fear
to miss profitable investment opportunities that may arise in the process of time.
While the transaction motive is of purely practical nature, both latter ones arise
from the need to counteract the effects of uncertainty. Which of them prevails with
respect to a certain market is partially dependent on the ease of entering and
exiting it; in particular, "...in the absence of an organized market, liquidity-
preference due to the precautionary-motive would be greatly increased; whereas the
existence of an organized market gives an opportunity for wide fluctuations in
liquidity-preference due to the speculative-motive."149 The three motives for
holding money translate directly into a non-negative liquidity preference and,
consequently, into the preference for assets that are "closer" to money. Thus,
storing wealth in goods that can be sold quickly and without discount should be
preferred to storing wealth in forms that are less easily convertible into money.
On the other hand, surrendering the state of perfect liquidity must be rewarded.
Keynes sees this reward in the rate of interest, which is also "a measure of the
unwillingness of those who possess money to part with their liquid control over
it."150 The higher the reward, the more prone are individuals to give up liquidity;
thus, liquidity preference is a function of the interest rate. However, it must be
noted that only the speculative motive is sensitive to the interest rate. Since the
rationale behind the precautionary motive does not refer to financial markets but
to the general future personal situation of the individual, there is no reason why
the amounts held for this reason should fluctuate with the rates of return on other
assets. In contrast, depending on the current situation, individuals may decide to
take advantage of the current opportunities or to wait for the
148 149 150

See Keynes (1936), pp. 170 ff. Keynes (1936), pp. 170-171. Keynes (1936), p. 67.
1.4 Economic Relevance of Liquidity

91

market situation to improve. Hence, changes in the economic prospects may lead to
fluctuations in liquidity preference due to the speculative motive. The main
conclusion from the above considerations, which give only a very brief outline of
the Keynesian theory, is the importance that individuals attribute to the
possibility of flexible disposal of money understood mainly as a mean of exchange.
The preference of the state of liquidity against the state of illiquidity results
from the uncertainty about the future and the wish to secure oneself against
unforeseen unfavorable developments, which can lead either to unplanned (or only
uncertain) expenditures or to new profitable investment opportunities. The
identification of the precise "psychological and business incentives to
liquidity"151 helps to understand the mechanisms and the consequences of this
phenomenon. Note that, although not explicitly stated in the "General Theory", the
considerations regarding liquidity preference are based on the assumption of
"certainty preference", i.e., the assumption that individuals prefer certain states
to uncertain ones. A similar preference for certainty arises also from the expected
utility model and is the reason for risk aversion.152 According to it, an
individual prefers (i.e., derives higher utility of) a moderate but certain pay-off
to an uncertain one having the same expected value, even though a chance of a
higher gain exists in the latter case. Thus, it seems that the very basic reason
why individuals should prefer, ceteris paribus, liquid to illiquid assets is
essentially similar to the reason why they should prefer, also ceteris paribus, low
risk to risky assets.153 The lack of precise knowledge about the future motivates
them to take measures against it by either choosing ways of storing wealth that are
less affected by uncertainty or by preparing to react to unexpected events
(opportunities) by holding sufficient funds in a liquid form.154 Giving up either
of these ways of cop151 152 153

154

This is the title of Chapter 15 in Keynes (1936). See section 1.4.2.1 for a brief
description of the expected utility model. The relation between liquidity
preference and the aversion to investment risk has been stated already by Tobin
(1958); he does it, however, for the purpose of explaining why cash holdings should
be negatively related to interest rates rather than for the investigation of the
nature of liquidity. Note, however, that the uncertainty underlying investment risk
and the uncertainty underlying liquidity are not quite of the same nature. Hicks
(1974, pp. 38 ff.) writes: "For liquidity is not a property of a single choice; it
is a matter of a sequence of choices. It is concerned with the passage from the
known to the unknown with the knowledge that if we wait we can have more
knowledge" (pp. 38-39). Thus, while investment risk refers to the uncertainty about
the consequences of a single investment decision, liquidity refers to the
uncertainty about a series of potential future de-
92

Chapter 1: The Concept of Liquidity

ing with uncertainty must be rewarded a risk premium is demanded in the former
case and a liquidity premium in the latter case. 1.4.2. Liquidity in Investment
Decisions

While the former subsection dealt with the role of liquidity in the economy in
general, the focus of this section is on its role from the investor's point of
view. Although the main conclusions from the former considerations still hold in
this case, the focus is more on returns from investments rather than on wealth
accumulation and consumption. In particular, the position of liquidity among
investment (and investors') goals needs to be discussed. Furthermore, the precise
delimitation of situations in which liquidity may become problematic needs to be
clarified. In the latter case, it is useful to distinguish between the cases in
which such problems can be anticipated and the cases in which they arise
surprisingly. Finally, the positioning of the "liquidity goal" in portfolio
decisions needs to be highlighted. All three aspects, i.e., liquidity as an
investment goal, "expected" and "unexpected" liquidity, and liquidity in portfolio
decisions are discussed in the following sections.

1.4.2.1. Investment Goals


Although highly relevant from the practical and theoretical point of view, the
discussion of investors' goals rarely goes beyond the "terminal value" or "return
and risk" level. The expected profitability and the uncertainty about it are
doubtlessly the key criteria for the majority of investment decisions, but they are
surely not the only ones, especially when non-public assets are considered. Even
intuitively, one can easily name further goals that can be highly relevant for at
least some groups of investors. Interesting references in this case are the studies
of investors' motives conducted in Germany. ADIG (1974) conducted a survey on the
most important features of a "perfect" investment; Ruda (1988) performed both a
theoretical, literature based, and an empirical analysis of goals of private
investors;155 Oehler (1990) questioned financial advisors on the characteristics of
investments that are considered important by their clients. A larger number of
various, not always clearly defined criteria were recorded
cisions. By holding liquid assets an investor assumes the possibility of learning
about new, yet unknown or uncertain opportunities, each of which may be subject to
investment risk. This idea is also expressed in the model by Jones/Ostroy (1984).
See Schmidt-von Rhein (1996) for a discussion of Ruda's (1988) results and their
comparison with other studies.

155
1.4 Economic Relevance of Liquidity

93

and evaluated in each of these studies. Rankings of investments goals, which looked
somewhat different in each case, resulted. A selection of the most relevant ones is
presented in Table 1-5.
Table 1-5: Rankings of selected investors' goals156 Goal ADIG (1974) 4 10 9 6 3 2 1
7 Ruda (1988) 6 19 5 17 13 3 4 16 11 1 8 7 2 Ruda (1988) Lit.* 2 11 6 5 11 3 4 6 1
8 Oehler (1990) 1 9 5 4 2 3 8 10 -

Dividend-Return Divisibility Ease of management Retirement provision Influence on


corporate policy Information and labor input Liquidity Long-term capital growth
Prestige Real value preservation Security Short-term profitability Tax-benefits
Total-Return

* based on the literature survey by Ruda (1988)

The first look at the presented goals reveals that they are highly heterogeneous,
partially inconsistent, and often not sufficiently precisely defined. Nevertheless,
the summary of the results allows the specification of only few issues that seem to
be of central relevance to investors:157

156

157

A compilation based on ADIG (1974), p. 94, Ruda (1988), pp. 20 and 219, and Oehler
(1990), p. 496. The surveys encompassed also further categories, which not always
could be classified as true investment goals (e.g., "investments recommended by my
bank"). They have been omitted in the Table, so that gaps in the rankings are
possible. It is also possible that different criteria have the same rank; they are
then to be viewed as equally important. Furthermore, not all categories were
identically named in each survey. Closest equivalents have been chosen where it was
possible in such cases. See also Schmidt-von Rhein (1996), pp. 109-110, for a
similar review. For similar notions see Schmidt-von Rhein (1996), pp. 111, Mller
(1995), p. 138, or Thiele (1977), pp. 31-40.
94

Chapter 1: The Concept of Liquidity return (encompasses such goals as dividend-


and total-returns, short-term profitability, long-term capital growth, and tax
benefits), risk (encompasses security, real value preservation, and suitability
as a retirement provision), liquidity, manageability (encompasses the necessary
information and labor input, ease of management, as well as divisibility).

The return and the risk goal are probably the most widely recognized in the
literature.158 The first one refers usually to the increase in wealth expressed as
a percentage of the invested capital. For most investments, total return can be
split into income return arising from the current payments (e.g., interest,
dividends, rental revenues, or cash flows) and capital growth arising from the
increase of the asset's value. Furthermore, depending on the logic behind the
concrete approach, several types of returns can be defined. They include mainly
holding period or discrete returns, which assume periodic payment and
capitalization of interest (income), and continuous returns, which are based on the
assumptions that interest is capitalized infinitely frequently. The latter
approach, apart from avoiding the necessity of specifying a uniform interest
payment interval, is also convenient for mathematical operations. The return goal
always refers to the future past returns can only be considered as achieving of
missing past goals. Therefore, it is always associated with uncertainty. The grade
of this uncertainty is different for different investments and is referred to as
risk. One must differentiate between uncertainty understood as the lack of any
reference point concerning the future and uncertainty in the sense of a probability
distribution for different future states only the second one is denoted as risk
and can be reasonably analyzed as an operational investment goal.159 A clear
delimitation of these two types of uncertainty is, however, difficult; yet, at
least a subjective assessment of
158

159

See Reilly/Brown (1997), Chapter 1, Bodie et al. (2005), Chapter 5, or virtually


any investment text-book. The classification of the general uncertainty into risk
(with known state probabilities) and uncertainty in the narrow sense (with unknown
state probabilities) goes back to Knight (1964), chapter VIII (first published
1921). See also Levy/Sarnat (1984), pp. 104-106, Kupsch (1973), p. 26,
Rehkugler/Schindel (1990), p. 105, or Bamberg/Coenenberg (1991), p. 17.
1.4 Economic Relevance of Liquidity

95

probabilities should usually be possible. Furthermore, investment risk can be


classified according to its source. Thus, one speaks of credit risk, market risk,
political risk, currency risk etc. Both, the return goal and the risk goal can be
derived from the expected utility theory.160 According to it, as already noted in
the previous subsection, individual's utility is typically an increasing function
of wealth or consumption161, but marginal utility is its decreasing function, i.e.,
it is concave. This shape of the function implies that individuals can be saturated
an increase in the holdings of each good separately and all goods jointly
contributes less and less to the overall utility. Furthermore, the utility of
uncertain wealth is equal to the expected utility over all possible scenarios.
These assumptions are sufficient to derive the return and the risk goal. On the one
hand, the fact that the utility function is increasing results in investor's
preference for investments leading to higher terminal wealth, i.e., yielding higher
rates of return. On the other hand, the fact that the function is concave leads to
the preference for more certain outcomes. To illustrate this, three investment
alternatives are depicted in Figure 1-15: the first one yields a certain wealth
level of X, the second one yields an uncertain wealth of Y or Y', and the third one
yields an even more uncertain wealth of Z or Z'. The expected wealth from investing
in any of these alternatives is equal X. Since the expected utility (U) of an
uncertain outcome is simply the utility of the possible outcomes weighted with
their probabilities, it lies on the straight line connecting U(Y) with U(Y') or
U(Z) with U(Z'). In effect, the utilities of investments yielding less certain
terminal wealths are lower. Hence, given identical expectations in all cases an
investor prefers the alternative with the lowest uncertainty, i.e., lowest risk.

160

161

The (expected) utility theory and the issue of risk aversion is discussed in
virtually every test-book on microeconomics; see Mas-Colell et al. (1995), Chapter
6, or Varian (2003), Chapter 12. For a more formal presentation see Ingersoll
(1987), Chapter 1. Since wealth can be considered as delayed consumption, the
choice of the variable for the utility function does not affect the conclusions.
96

Chapter 1: The Concept of Liquidity

U(X) U(Y,Y' U(Z,Z')

Utility

Z Y

Y'

Z'

Wealth

Figure 1-15: Decreasing marginal utility and risk aversion162

Liquidity as an investment goal is, of course, especially relevant for this work.
Its extensive definition has been provided earlier in this Chapter. Although it is
most frequently described in the literature as the "ease of conversion into
money"163, it follows from the hitherto discussion that this is only a common
heading for a bundle of goals encompassing the time and the value aspect of
liquidation. They can be summarized in two sub-goals: the expected present value of
sale receipts, either in absolute terms or in relation to the (however defined)
"fair value", and the uncertainty about it. This means that investors should strive
to maximize the present value they expect to receive at sale (i.e., marketability)
and simultaneously to minimize the uncertainty about it (i.e., liquidity risk). The
analogy to the return and risk goals is apparent; however, while the latter refer
to increases of wealth, marketability and liquidity risk refer to liquidation
outcomes. The two basic liquidity sub-goals can be further categorized depending on
the investor's situation and also extended on the purchase of assets; this is done
in the following subsections. Manageability is the last of the four and a far less
frequently recognized investment goal.164 It refers to the effort necessary to
conduct an investment and can have a num162 163

164

For similar presentations see Mas-Colell et al. (1995), p. 186, or Varian (2003),
p. 225. See Thiele (1977), p. 33, Fank (1992), pp. 206, Schmidt-von Rhein (1996),
pp. 104-105, as well as the literature references in section 1.1.1. In fact, many
authors omit the manageability goal reducing the list of investor's goals only to
return, risk, and liquidity; see Fank (1982), pp. 206 ff., or Lerbinger (1984), pp.
142 ff.
1.4 Economic Relevance of Liquidity

97

ber of different forms. In the first line, it may be the effort of gaining
sufficient information to evaluate and to monitor an investment but also
information that the specific investment alternative is at all available.
Furthermore, some assets require more engagement of the investor than other assets.
For instance, regulations may require that certain legal steps are conducted
personally, or the nature of the investment may require frequent revisions of the
initial decisions. Obviously, investors should prefer (ceteris paribus) investments
that can be accomplished with as little effort as possible. This can be done by
choosing an asset that has the corresponding characteristic or by transferring the
efforts on a hired manager. In the last case, the management fee would diminish the
payout; thus, manageability can be considered as a return reducing factor. The four
main investment goals identified here are not entirely independent. The directions
of the relations between them are outlined in Figure 1-16 in form of an "investment
goals' square". The negative link between expected return and risk is a commonly
recognized rule for accepting risk investors must be rewarded with higher
returns.165 Similarly, lower liquidity and poor manageability need to be
compensated with additional return premiums to cover the additional costs. The risk
increasing character of illiquidity has been discusses in section 1.1.2; also high
complexity of an investment may result in increased risk due to a higher
possibility of wrong decisions. Finally, as discussed in section 1.2.3.2, poor
liquidity of an asset may make a more thorough search for a trading partner
necessary (or worthwhile) increasing the effort necessary to conduct and to
conclude the investment.

165

See literature references in FN 158. The relation between expected returns and risk
is usually justified with the CAPM (see section 4.1.3).
98

Chapter 1: The Concept of Liquidity

Return Liquidity positive influence negative influence

Risk

Manageability

Figure 1-16: Interrelations between the main investment goals

After presenting the general position of liquidity among investment goals, it is


necessary to state more precisely what the concrete objectives are. It has already
been highlighted that liquidity is, in fact, a dual goal encompassing the expected
outcome of liquidation (marketability) and the uncertainty associated with it
(liquidity risk). Still, there are at least three different situations in which an
investor is confronted with this problem, each of them resulting in a slightly
different specification of the original goal. They are discussed in the following
sections and play a significant role in the development of the search model in
later chapters.

1.4.2.2. Expected and Unexpected Liquidation


The first important differentiation of the liquidity goal is with respect to the
moment of liquidation. Investors are usually facing liquidation problems associated
with an illiquid asset at the end of the investment horizon. When the planned
holding period expires and the asset is to be sold, the issue of its liquidation
value and liquidation time arises. The second type of situations in which investors
are concerned with liquidity is an unexpected sale caused by exogenous
circumstances. Due to unplanned and possibly unforeseeable events, quick access to
larger sums of money may be required in order to meet payment deadlines. This is
often achievable only by selling some of the investor's asset holdings. These two
situations are basically similar in their nature investors are interested in a
quick and cheap liquidation in either case. However, differences
1.4 Economic Relevance of Liquidity

99

in the backgrounds of the sale decisions can lead to emphases on different aspects
of the liquidity goal. Consider the expected liquidation case first. Since most
investments are conducted with a certain intended time horizon, it is apparent that
their liquidation is scheduled more or less precisely already at the moment of the
investment decision. Its outcome is relevant with respect to the price achieved and
to the duration of the process. On the one hand, the sale price significantly
affects the total return from the investment; on the other hand, timely sale may be
necessary to meet the scheduled times of subsequent investments. Thus, the first
aspect is important for maximizing the profitability of the investment, and the
second aspect determines the incurred opportunity costs defined as the profits lost
due to delays in the investment schedule. The fact that the sale time is known (at
least approximately) should lead to relatively higher emphasis on the sale price.
Since the liquidation deadline and the consequences of missing it can be assessed
in advance, they can also be adequately mitigated. In particular, the liquidation
process can be initiated accordingly earlier in order to minimize the chance of a
delay. Furthermore, emergency financing necessary to bridge the time gap between
the sale of the illiquid asset and the new investment in case of a delay can be
arranged in due time at an acceptable cost. The planning certainty can be
additionally enhanced by a forecast of the market situation at the moment of the
sale. All in all, since the time aspect of liquidation can be relatively well
managed in this scenario, investors' main concern should be obtaining an adequate
sale price. In contrast, investors' focus in the case of an unexpected liquidation
should be more on the time aspect. The liquidation is then the result of an
unforeseen event, a liquidity shock forcing the investor to sell the asset earlier
than actually intended. This has two profound consequences. Firstly, due to the
discontinuation of the investment, its original goal cannot be achieved; and
secondly, failure to sell the asset in due time may result in severe consequences.
These consequences may encompass a variety of costs, including lost customers and,
in consequence, lost future revenues, financial penalties, like the penalty
interest for delayed installment payments, or missed opportunities of particularly
profitable investments. In the worst case, also bankruptcy due to the inability of
timely debt repayment may follow. Thus, the investor needs to compare the return
lost due to the premature termination of the investment with the cost resulting
from forgoing the liquidation; obviously, liquidation is only rational if the
former one
100

Chapter 1: The Concept of Liquidity

does not exceed the latter one. Although the nature of this problem is similar to
the planned sale, there are two significant differences: the opportunity costs of
not selling are much higher, and the timing of the liquidity shock is unknown.
Hence, time is more important in this case than in the case of an expected and
planned liquidation inducing a more time-oriented attitude with respect to the
liquidity goal. The distinction of the two types of "liquidity situations" has
profound practical consequences. While relative certainty (or at least expectation)
concerning the timing, the opportunity costs, and the state of the market can be
assumed for the planned liquidation, all these variables are either unknown or only
imprecisely assessable for the unexpected liquidation. In fact, the only statement
that can be made in the latter case is that opportunity costs are likely to be
high. This makes the unexpected liquidation far more problematic than the excepted
one. For this reason, the liquidity goal formulated by investors will usually refer
mainly to this case.166 It does not mean, however, that liquidity in the planned
sale case can be ignored. Since each scenario requires the application of a
different analysis framework, they are often discussed separately in the following
chapters.

1.4.2.3. Liquidity in the Sale Case and in the Purchase Case


Another two types of situations that may lead to different notions of the liquidity
goal are sale and purchase of an (illiquid) asset. Hitherto, only the former case
has been considered. Yet, it has already been stated several times that liquidity
considerations may also become relevant when buying an asset the definition of
liquidity formulated in section 1.1.3 includes also this eventuality. At this
point, it is necessary to clarify whether and in how far investor's goals differ in
these two cases. The general objectives when buying or selling an illiquid asset
are symmetric. In the former case, the investor aims at maximizing the effective
sale price, and in the latter case, she aims at minimizing the effective expense.
Minimization of uncertainty is present in a similar manner in both cases. However,
differences become apparent when the decision variables are considered more
closely.

166

This conclusion is in line with the Keynes' notion of liquidity preference due to
the precautionary and the speculative motive (see section 1.4.1). The possibility
of a timely liquidation in an emergency case seems also to be in the focus of the
literature on the subject.
1.4 Economic Relevance of Liquidity

101

In the first place, as already discussed in section 1.2.2, the transaction costs
are not necessarily symmetrical in both considered cases. Direct fees and taxes are
usually charged on one side of the transaction only; also inspection and evaluation
(appraisal) costs are usually higher on the buyer's side. Yet, while this problem
can be solved by allowing for the respective expenses in price negotiations, the
issue of opportunity costs is much more problematic. As mentioned in section
1.2.2.3, "lost opportunities" in the sale case encompass revenues that could have
been earned or losses that could have been avoided if the liquidation was
accomplished promptly. In contrast, income flow and value appreciation of the
prospecttive investment are lost or postponed if the transaction is delayed in the
purchase case. This means that while opportunity costs are solely a function of the
personal situation of the concrete investor in the former case, they depend mainly
on the characteristics of the asset in the latter case. In other words, they are
predominantly investor-specific when selling and predominantly assetspecific when
buying.167 Due to this property, liquidity shocks resulting in the necessity of an
unexpected sale are in practice far more relevant than liquidity shocks resulting
in the necessity of an unexpected purchase. The latter may occur in certain less
typical situations, such as delivery of the underlying in a forward agreement, but
are less frequent and usually of less severe consequence than unplanned, forced
sales conducted to bridge liquidity bottlenecks. Also, certain types of market
organization may lead to different positions of sellers and buyers. For example,
real estate brokers usually represent sellers and actively seek for buyers.
Although a buyer may also turn to a broker, she will usually be directed to the
already known sellers an active search for a property to purchase is rarely
offered. Similarly, auctions, such as the typical English one, are only organized
in order to sell an item but not in order to buy one. Hence, some forms of trading
seem to favor sellers. Finally, characteristics of market participants do not
necessarily need to be the same on the supply and on the demand side of the market.
This refers both to the availability of sale offers or buy bids and to the
diversity of valuations among potential buyers or sellers. Especially in unusually
hot or cold markets, it may be easier to sell or to buy, respectively.
167

This statement is only valid for typical transactions. Counter-examples of special


situations, in which transaction costs are asset-specific at sale or investor-
specific at purchase, can be easily found. This is, e.g., the case when the sale is
a short-sale, i.e., a speculation or a hedging strategy based on a decrease in the
asset's value, or when the value of the purchased asset results from its special
function for the concrete investor.
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Chapter 1: The Concept of Liquidity

To sum up, there are a number of reasons why liquidity considered from the seller's
point of view may be different than liquidity considered from the buyer's point of
view. For practical investment analysis and decision making, this means that
considerations referring to liquidity as an investment goal need to be structured
differently in these two cases.

1.4.2.4. Individual Liquidity and Portfolio Liquidity


The definition of asset liquidity refers to only one asset; the definition of
market liquidity includes considerations about the amount of liquidated assets, but
it still refers to only one asset type. Recognizing that the concept of liquidity
can also be applied to the entire wealth (or a part of it) of an individual or an
institution introduces a new aspect to the problem. The dual nature of liquidity as
an investment goal has been emphasized in the discussion in section 1.4.1.
According to it, investors should prefer (ceteris paribus) assets yielding higher
expected liquidation values as well as assets offering more certain liquidation
values. This set of objectives can be applied to investment portfolios in the same
manner as to individual assets. It would then mean that investors prefer portfolios
that can be liquidated at higher expected values as well as portfolios which
liquidation values are more certain. Although these two notions of the liquidity
goal appear to be nearly identical, there is one important difference, which
becomes especially apparent when an unexpected sale is considered. Coping with a
liquidity shock requires that a certain amount of money is put to investor's
disposal at short notice; this is achieved by selling some of her asset holdings.
The concept of individual liquidity assumes that one concrete asset is sold in such
case. However, as soon as the investor holds more than only one asset (asset type),
the possibility of selling any one of them occurs. Liquidation in this sense refers
to a part of the total wealth without determining precisely which part is to be
sold. The only condition is that the total proceeds are sufficient to cover the
unexpected expenses. Also liquidity risk can be redefined in this manner. It refers
then to the certainty about the effective outcome of the liquidation of any of the
held assets. The liquidity goal in the portfolio context implies that the investor
attempts to sell more than one asset simultaneously. In this case, expected sale
proceeds are equal to the (conditional) sum of expected proceeds from one or, if
necessary, several assets
1.4 Economic Relevance of Liquidity

103

that sell first. Thus, the expected liquidation value does not essentially differ
from the single asset liquidation case. However, the same does not hold for
liquidity risk. The chance of successfully selling any asset is always higher, or
at least not lower, than the chance of selling some particular asset. Thus, the
uncertainty about obtaining the required sum quickly is lower in this case, or
alternatively, a higher sum is obtainable within the given time horizon at the
given level of uncertainty. This means that liquidity risk is generally lower for a
portfolio than for any single asset in this portfolio. Thus, holding a mixture of
less liquid assets may result in a similar liquidity position as holding one more
liquid asset.168 Note that the above notion of portfolio liquidity is similar to
the corporate liquidity discussed in section 1.1.1.3. Companies that have the
ability to cover all their expenses on time are denoted as liquid. This ability is
usually judged on the basis of assets and liabilities disclosed in the balance
sheet. In fact, assets of a company can be regarded as a portfolio that can be
liquidated in an emergency situation. However, while corporate liquidity focuses
mainly on holding sufficient stock of liquid assets, portfolio liquidity is also
about the variety of assets. In this sense, the liquidity position of a company
owing only one large piece of equipment is worse than the respective position of a
company owing a larger number of smaller devices. The latter one is facing lower
liquidity risk, because it can choose to liquidate only a part of its assets in an
emergency case. Intuitively, portfolio liquidity seems to be a more appropriate
investment goal than liquidity of individual assets. Like in the case of other
goals, in particular the return and the risk goal, an investor should be concerned
about liquidity of her investments viewed as a whole and not separately.169 Thus,
this aspect of the problem receives special attention in the following chapters,
especially in Chapter 4. *** The main objective of this Chapter was to clarify the
meaning of the central term of the book. Despite its widespread use, no unambiguous
and generally accepted liquidity definition seems to exist. The literature review
demonstrated that the term is used in at least three different contexts referring
to assets, markets, and companies but even
168 169

"Liquidity risk diversification" is analyzed more closely in sections 4.3.3 and


4.2.3. See section 4.1 for portfolio considerations referring to the return and
risk goal.
104

Chapter 1: The Concept of Liquidity

within these contexts there is no consensus about its precise meaning. Thus, the
task was, on the one hand, to categorize the existing definitions, and on the other
hand, to work out a precise description of the phenomenon denoted as liquidity. On
this basis, the foundation for the development of measurement approaches and
investment decision tools, which would take liquidity into account, was to be
prepared. The extensive analysis led to several conclusions of which three are of
particular importance for the following chapters. In the first line, the definition
of liquidity was addressed. The central result from the analysis of the existing
approaches, extended by own considerations, was the recognition that it has two
distinct and largely independent dimensions. On the one hand, the expected outcome
from liquidation is relevant; on the other hand, the uncertainty about it is also
important. These dimensions have been denoted as marketability (referring to
assets) or expected liquidity (referring to markets) and liquidity risk,
respectively. In the second step, the sources of the problem have been examined. A
number of variables, which in a more or less direct way affect the possibilities of
liquidating an asset, have been classified into three main groups: transaction and
opportunity costs, organization of trading, and heterogeneity of opinions about the
value of the asset. An important "side effect" of this analysis was the recognition
of the importance of the search for a trading partner. As it seems, liquidity
understood as the ability to sell quickly, without discount, and with little
uncertainty can be interpreted as the ability to find a trading partner offering a
"good" price within a short period of time and with high confidence. In this sense,
modeling the "seek and sell" process is equivalent to modeling liquidity itself.
Finally, the review of the main types of illiquid investments led to the
recognition of the role of real estate, which proved to be by far the most
important one. Volumes invested in properties are of magnitudes comparable with
other popular assets like stocks or bonds. In contrast, other illiquid assets,
among them private equity and various collectibles, are only of marginal practical
relevance. For this reason, further analysis in the book is focused primarily on
real estate.
Chapter 2 Search in Illiquid Markets

As stated in the previous Chapter, the necessity to search for a trading partner
seems to be the key factor in understanding liquidity. It directly affects the
possibility of quick liquidation at a reasonable price but is difficult to specify
in a way that would allow its inclusion in the investment decision process. This
Chapter concentrates on the formal description of the search process. A sequential
search model has been chosen for this purpose. The function of the model is
twofold: on the one hand, it should allow the quantification of the influence of
various market parameters on the final result of liquidation; on the other hand, it
should provide methods for analyzing various search strategies and identifying the
optimal one. However, these two issues cannot be entirely separated the effect of
the market situation on the outcome of search depends on the chosen search
strategy, and the optimal strategy is to a large extent determined by the
characteristics of assets and markets. Thus, the central issue of the analysis is
the dependence between the liquidity of an asset and the strategic choice of an
investor. The Chapter starts with a brief presentation of the "Theory of Search", a
branch of mathematics and operations research dealing specifically with search
processes. An introduction to search models follows. Two seminal models that
constitute the foundation for most of the search theoretical analysis are in its
core: the basic model with observation costs and Karlin's model with discounting.
The prime objective is to provide the methodical foundation for the formulation of
a real estate search model in the next section, but also to give the reader a
better impression of the nature of the problem. A model of search conducted by an
investor liquidating a real estate investment constitutes the central point of the
Chapter. It builds on a simple model with observation and opportunity costs but is
refined by adding several more realistic assumptions about the key parameters. Main
modifications include continuous time and market uncertainty as well as the
redefinition of the variables in a relative manner. A closed form formula for the
expected net receipts is derived and conditions for the existence of a gain
maximizing search strategy are considered. Recognizing the limitations of the
model, a number of possible extensions are discussed in the following section.
Finally, a simulation approach to the search problem is presented. It allows for
more freedom with regard to
106

Chapter 2: Search in Illiquid Markets

restricting assumptions but yields only approximate results. The Chapter is closed
with some more general considerations about the implications of strategic search
for the functioning of illiquid markets.

2.1.

The Theory of Search

Sequential search models have been developed and applied in economic sciences for
the last several decades already. They are also known as optimal stopping models
since they focus on the optimal stopping of a sequence of random variables, which
can be interpreted as a search process. The main interest is usually in finding a
stopping rule that optimizes the expected outcome of the search. Numerous
variations of this problem have been analyzed in the literature. Despite
differences in constraints and objectives, their core structures remain similar.
However, like in many mathematically complex problems, even seemingly slight
modifications can lead to significant complications or even to the insolvability of
the model. Research on the sequential search theory follows therefore a twofold
aim: application of the models to certain real world phenomena and development of
further variants of the problem. The pioneering work in the field of search theory
was done by Wald (1947a) and Arrow et al. (1949). They analyzed sequential decision
problems and formulated several basic theorems useful in the analysis of series of
random variables. The originally intended application was in statistical estimation
and testing based on sequential sampling, but more general application
possibilities were also indicated.170 The rapid development of the actual "Theory
of Search" started about 1960. Mathematical elaborations constitute the largest
part of the search theoretical research.171 One of the first papers formulating the
standard search problem was MacQueen/Miller (1960). The authors use the house
buyer's dilemma as an example of a search problem. They derive the optimal
reservation price, i.e., the minimal price that should be accepted, and formulate
conditions for its existence and uniqueness. Among later significant mathematical
contributions are: Chow/Robbins (1963), Karlin (1962), Elfving (1967), or Siegmund
(1967). The paper by Karlin is especially interesting for the analysis in this
book. The author studies the optimal behavior of an individual sell170 171

See Wald (1947), p. 280. A lot of the early development in this field is summarized
in DeGroot (1970), pp. 265 ff., Chow et al. (1971), Lippman/McCall (1976a), and
Ferguson (2000).
2.1 The Theory of Search

107

ing an asset and willing to maximize the expected receipts. He analyzes the optimal
search policy in several frameworks including discrete and continuous time as well
as finite and infinite horizon and also introduces discounting of future payments.
Further papers on the search theory consider special cases of the problem, e.g.,
when the searcher is allowed to "recall" past offers,172 when the distribution of
offers is unknown, and the searcher "learns" from subsequent observations (adaptive
search),173 or when the search environment is dynamic174. The possibilities of
generating different search frameworks are almost infinite,175 but their
solvability is often problematic. Therefore, a separate branch of the search theory
addresses the formulation of practicable solutions to the existing problems. Two
frequent approaches include analytical derivation of explicit solutions under
simplifying assumptions176 and derivation of approximate solutions.177 While the
former allow more precise answers, the latter are more general. Most papers on the
"mathematical" search theory consider the sequential search problem as a class of
abstract mathematical problems. Its different variations are referred to as the
"secretary problem", the "parking problem", the "one-handed-bandit problem", or the
"house selling problem". Although these names suggest relations to real live
situations, the papers remain mostly on an abstract theoretical level. A series of
random variables on which a target function is applied and optimized is always in
the centre of the analysis. The relevance of these works for the subject of this
book is therefore mainly due to the methods of analysis of various search problems
developed therein. The domain of economics most influenced by the theory of search
is information economics. This course of research was introduced by Stigler (1961).
In this groundbreaking paper the author concentrates on the role of asymmetric and
heterogeneous infor172

173

174

175

176 177

See Yahav (1966), DeGroot (1968), Rosenfield/Shapiro (1981), and Rosenfield et al.
(1983), as well as section 2.3.3.3. See Telser (1973), Kohn/Shavell (1974),
Rothschild (1974a), Albright (1977), Rosenfield/Shapiro (1981), Rosenfield et al.
(1983), or more recently Einav (2005). See Karlin (1962), McCall (1965),
Lippman/McCall (1976c), and Ondrich (1987a), as well as section 2.3.3.2. Examples
of other special cases are the "search and evaluation" model of MacQueen (1964) or
the "Pandora's Problem" of Weitzman (1979). See Telser (1973), Gastwirth (1976),
Albright (1977), and Feinberg/Johnson (1977). See DeGroot (1968), Kennedy/Kertz
(1991), and Khne/Rschendorf (2000 a, b).
108

Chapter 2: Search in Illiquid Markets

mation in economic processes, especially in the market price ascertainment. Stigler


points out that in the absence of an organized market no single price exists. An
individual wanting to buy or sell an asset will therefore not accept the first
quote, but search for the best one she can obtain. "Searching" means in this case
observing different offers and gathering information about others' opinions on the
asset's value. Thus, it can be seen as a method to cope with insufficient
information. In this sense, search is valuable and its value is equal to the
additional gain achieved by searching. This idea inspired numerous authors to study
the role of search as a source of information. One of the most significant
following papers is McCall (1965) where valuation of information is recapitulated
and generalized. The far reaching consequence of Stigler's idea was the development
of market models with imperfectly informed participants searching for best
alternatives. Numerous works deal with market organization and equilibrium in this
context building directly on Stigler.178 Others, following Nelson (1970), analyze
consumers' behavior in markets with non-homogenous products.179 Several papers
address the problem of price setting by companies acting under incomplete
information.180 Another major field of application of the search theory is labor
economics. This course of research was introduced by Stigler himself (1962) who was
followed by McCall (1970) and other researchers in the 70s181. The search for a job
is analyzed in these works. The key issue is maximizing the expected future
earnings of a potential employee. Most of these studies concentrate on the optimal
search behavior and on the explanation of the unemployment phenomenon as well as
other characteristics of labor markets. The research on this subject is still
lively. McCall (1994), who examine the effects of job heterogeneity, or Pissarides
(1994), who analyze an on-job-search, are examples for the more recent developments
in this field.

178

179 180 181

See Rothschild (1973), Burdett/Judd (1983), and several articles published in the
Swedish Journal of Economics, Vol. 76, 1974. See Gastwirth (1976), Wilde (1981), or
Cressy (1983). See Rothschild (1974b) or Axell (1977). See Alchian (1970),
Mortensen (1970), Pissarides (1976), and Lippman/McCall (1976 a, b, c). Several
significant search theoretical contributions in labor economics can be found in
Lippman/McCall (1979). A good review of the research on this subject is brought in
MacKenna (1985).
2.1 The Theory of Search

109

Reference to real estate economics has been present in the search theory from its
very beginning and is best reflected in the "house selling problem"182, which deals
with the dilemma of a house owner wanting to sell a property and searching for the
best buyer. However, despite the relation to a property transaction, the analysis
of this scenario concentrates mostly on the general search problem using the house
only as an example and ignoring the unique characteristics of real estate markets.
Specific applications of the search theory in real estate economics are relatively
recent. One course of research is the analysis of the search behavior of market
participants.183 Several papers focus on the role of broker in this process.184
Another often discussed problem is the marketing time of properties. The relevance
of search in this context was mentioned already by Miller (1978, pp. 165-167), but
it was directly applied by Haurin (1988) for the first time. The latter author
utilizes the search theory to study the effects of residential houses' atypicality
on their marketing times. His followers study relations between listing price,
marketing time, and the eventual selling price.185 Studies on liquidity
(illiquidity) belong to the most recent applications of the search theory in real
estate economics. Research on this subject started with Lippman/McCall (1986) and
has been followed by relatively few researchers so far.186 There have also been
numerous applications of the search theory in many other branches of economics.187.
The relevance of various applications of the search theory in fields of research
not necessarily directly connected with liquidity is given by the fact that the
nature of the search process and the encountered mathematical problems are very
similar in all markets with imperfect information. Their formulations vary, but the
core structures remain analogous sequential search is conducted and should be
optimized. This quality allows the application of the same methodology in most
cases.

182

183

184 185 186 187

The "house selling problem" is defined and analyzed among others by MacQueen/Miller
(1960) and Albright (1977). See also Ferguson (2000), pp. 1.4-1.5. See Courant
(1978), Chinloy (1999), Cronin (1982), Quan/Quigley (1991), Kim (1992), or
Yava/Colwell (1995). Yava (1992) and Arnold (1999) incorporate bargaining between
the buyer and the seller in their search models. See Yinger (1981), Wu/Colwell
(1986), Geltner et al. (1991), or Yava (1996). See Yava/Yang (1995), Glower et al.
(1998), and Green/Vandell (1998). See Chinloy (1999), Krainer (1999, 2001), and Mok
(2002 a, b). Further applications of the search theory include i.e. modeling
research and development activity (see Nelson, 1961, Marschak/Yahav, 1966, or
Reinganum, 1982) or valuation of financial instruments (see Karatzas, 1988, or
Beibel/Lerche, 1997).
110

Chapter 2: Search in Illiquid Markets

2.2.

Introduction to Search Models

Two models of sequential search for a trading partner constitute the core of the
following section. They are based on MacQueen/Miller (1960) and Karlin (1962),
respectively, and have been widely discussed in the literature so far. Due to the
structural simplicity, they allow for only few variables and include a number of
simplifying assumptions. However, the simple structures of these models should not
mislead about the full potential of search-theoretical approaches. By implementing
additional variables and modifying the search framework, they can be used to study
highly complex problems. Therefore, the models in this section should be treated as
an introduction to the actual subject of the Chapter. 2.2.1. Search Framework

Before the mathematics of the search models are introduced, it is necessary to


provide precise definitions of all relevant variables and parameters in order to
avoid confusion when the analysis becomes more complex. The explicit presentation
of the model framework is also useful to give the reader a better impression of
what kind of problem is dealt with. For this reason, the setting of the model is
held as simple as possible at this stage. The underlying search process is
summarized in Figure 2-1.188 A sale of an illiquid asset is considered. It is not
necessary to specify the type of the asset at this point, but several assumptions
concerning its key features as well as the characteristics of the seller are
necessary.189 Firstly, it is assumed that no objective valuation of the asset in
question is possible. As a result, potential buyers differ in their assessments of
the asset's true value. Several different sources of this heterogeneity of opinions
are possible: it may result from different possibilities of use, which generate
different income streams, or simply from different subjective tastes. The owner
does not use the asset for her own purposes and regards it purely as a financial
investment. In particular, it may be a part of her investment portfolio. This
assumption implies that

188

189

The trade framework presented in this section is based on standard search models of
asset sale as analyzed by MacQueen/Miller (1960), Stigler (1961), Karlin (1962),
McCall (1965), or Rosenfield et al. (1983). Its core structure is the same as in
the job search models presented by McCall (1970), Lippman/McCall (1976a),
Lippman/McCall (1979), pp. 2-3, or MacKenna (1985), pp. 4-5. Analogical frameworks
of real estate trade are used by Miller (1978), Haurin (1988), or Tryfos (1981).
For better tractability, the seller (investor) is assumed to be female while
potential buyers (market participants) are assumed to be male.
2.2 Introduction to Search Models

111

the seller does not need to combine the sale with any other activity or transaction
it is viewed on a standalone basis. For the analysis conducted in this Chapter,
it is also convenient to assume that the seller (investor) is risk-indifferent,
i.e., she judges investment opportunities only by expected gains ignoring other
characteristics. This results in the notion of an optimal search strategy as the
one that maximizes the expected receipts. This assumption is, however, only
temporary and will be dropped in the subsequent chapters. Trying to sell the asset,
the seller searches for the best buyer (or bidder), i.e., one that offers the
highest price. It is assumed that no other feature is of importance. Especially,
the seller is not concerned about what happens with the asset after the sale the
time after the transaction is beyond her consideration. The seller has also no
preferences concerning the characteristics of the buyer, including his
creditworthiness. All potential buyers are assumed to have the same perfect
financial standing and will be able to pay the price they offer without delay.
Reassuming, the only thing that matters is the price. Furthermore, the seller is
concerned about the duration of the search only as far as it influences the gain
from the sale. This means that no deadline is set for completing the sale and the
search can continue as long as needed to maximize the effective sale price. The
seller continues the search until the asset is sold. During this time, prospective
buyers bid on the property placing their purchase offers sequentially.190 It is
assumed that only one offer can be viewed at a time and that the search starts with
the arrival of the first one.191 Offers are enumerated with an index i according to
their arrival order starting with i=1. Intervals between subsequent bids are
assumed to be non-random, identical, and equal to t. Each potential buyer offers a
price of Pi, which is based on his subjective opinion about the value of the asset.
The seller can either accept it or reject it; however, she has to make her decision
immediately, and if she chooses to reject an offer, it cannot be recalled
afterwards. Since potential buyers do not know and do not
190

Note that the term "offer" is used throughout the analysis in the sense of a bid
placed by a prospective buyer, as is typically done in the search theory. In
particular, it should not be confused with the "offer-price" demanded by a seller;
the term "ask-price" is used in this context when necessary. 191 In later sections,
intervals between subsequent bids are assumed to be random rather than constant.
The beginning of the search is then associated with the decision to sell the
property. In this case, the starting point of the search process does not
necessarily need to (and indeed usually doesn't) coincide with the first offer. The
reader should bear in mind some minor differences in model's equations arising from
this fact when comparing the results in this book with those in other works.
112

Chapter 2: Search in Illiquid Markets

influence each other, their opinions are independent. Under the assumption that
they arrive in a random order and that their valuations are unknown before the
arrival, a price offer Pi can be viewed as random variable and a series of price
offers (P1, P2, ...) as a sequence of independent random variables.192 Probability
distributions of the bids arise from the distribution of opinions on the asset's
value among market participants. If valuations of potential buyers are constant
over time (static market), offers are independent and identically distributed
(i.i.d.) and can be treated as realizations of one random variable P. The search is
assumed to be costly. Two types of search costs are possible: observation costs and
opportunity costs. The two standard models presented in this section use either the
first (basic model) or the second alternative (Karlin's model), although both cost
types can also be combined, as is done in the real estate search model later on in
this Chapter. Observation costs are connected with obtaining further offers. They
may encompass, for example, advertising and representation expenditures, costs of
visitations, travel expenses etc. Not included are, however, typical transaction
costs, like fees, taxes etc., which are assumed to be already comprised in prices.
The unit observation cost of c is constant and is accrued each time an offer
arrives, i.e., regularly at intervals of t. So, if the search is terminated after
the nth offer, the cost of c is borne n times. Opportunity costs arise from the
fact that the seller cannot dispose of the capital bounded in the asset for other
purposes as long as it remains unsold. This cost of delaying the sale is reflected
by the discounting factor used to calculate the present value of future payments.
It is assumed to be positive and smaller then 1. The search for the best buyer runs
according to a certain strategy, which may remain unchanged or vary depending on
the offer flow. The seller defines a set of criteria according to which she decides
whether to accept or to reject an offer. The possibilities of different search
strategies are almost infinite. The strategy considered in most sequential search
models and also followed in this work is to set a reservation price pi*, a critical
price above which any offer is automatically accepted and below which every offer
is automatically rejected. While p*i applies only to the ith offer, a constant
reser-

192

Note that random variables are labeled with capital letters and their realizations
with small letters. Thus, Pi represents a yet unknown price offer (ex ante) and pi
a price offer that has already been made (ex post).
2.2 Introduction to Search Models

113

vation price valid for the whole duration of the search is assumed in many models;
it is denoted as p*.

Beginning of the search t1 Cost of c Pool of potential buyers t2 TIME Cost of c t3


Cost of c t4 ... ... Offer P1 P1<p*1 P1>p*1

Offer P2 P2<p*2

P2>p*2

Offer P3 P3<p*3

P3>p*3

...

Total search cost


Discounting

Sale price of Pi

et receipts from sale

Figure 2-1: Scheme of the search process

It must be stressed that the described selling problem is only an example for a
family of similar problems. The same framework can be used, e.g., to describe
consumer's search for the best product, employee's search for the job, or other
mentioned in section 2.1. What underlies all these problems is in fact a much more
general case of acting in a heterogeneous environment.
114 2.2.2. Search Strategy

Chapter 2: Search in Illiquid Markets

Before the actual models are presented, it is necessary to discuss several general
issues encountered in the analysis of each search problem. The central question is:
which search strategy is the best? Two basic possibilities are a fixed sample
strategy and a sequential search strategy.193 In the first case, the searcher
reviews a predefined number of offers before she decides to choose the highest one.
The second possibility is to decide immediately on each arriving offer whether to
accept it and complete the sale, or whether to reject it and continue searching. It
seems intuitive that the latter method should generally produce better results.
While collecting a fixed number of offers, each of which generates a unit
observation cost, it is possible that the search would continue even after
receiving an unexpectedly high offer. The sequential procedure allows avoiding such
unnecessary search costs by terminating the search as soon as no prospects for a
better offer exist. It is economical to continue the search only as long as the
expected marginal revenue from viewing further offers exceeds the marginal cost.194
It fact, it can be proved that the sequential approach generally dominates the
fixed sample strategy in terms of a higher expected revenue.195 Therefore, only the
sequential search strategy is considered in the following analysis. It must be
stressed, however, that its dominance only holds under certain conditions, which
are similar to those assumed in section 2.2.1. Under different model assumptions
other search strategies may be advantageous.196 Especially, if a mixed strategy is
allowed, i.e., one in which whole samples rather than single offers are reviewed
and decided on sequentially (sequential sample picking), it may be the optimal one
for a wide class of search problems.197

193

194 195 196

197

The fixed sample strategy is considered by Stigler (1961) and Stigler (1962); the
sequential search strategy is used by MacQueen/Miller (1960), McCall (1965) as well
as in the majority of the search theoretical literature. See Rothschild (1974a), p.
691 or MacKenna (1985), p. 10. For the poof see DeGroot (1970), pp. 267-272, and
MacKenna (1985), pp. 7-13. Feinberg/Johnson (1977) demonstrate for several
specified distributions of offers that the superiority of the sequential search
depends on the level of search costs. Wilde (1977), p. 375, argues that economies
of scale leading to lower search costs may cause a fixed sample strategy to
dominate the sequential one. See also FN 195. The optimality of the mixed strategy
is indicated by Gastwirth (1976) and analyzed by Gal et al. (1981), Morgan (1983),
Morgan/Manning (1985), or Harrison/Morgan (1990). Mok (2002b) applies a mix
strategy search model on real estate.
2.2 Introduction to Search Models

115

Another problem of sequential search models is the existence of an optimal


procedure. Optimality is understood in terms of the maximum expected sale proceeds
in virtually all search models. This holds for a risk neutral investor assumed in
this Chapter; however, one should bear in mind that also other definitions of
optimality, including risk minimizing, are conceivable. This subject is discussed
more closely in the following chapters. It can be proved that under certain
conditions a receipts maximizing search procedure (stopping rule) always exists and
is fully described by a stopping variable.198 This variable is a function of past
observations and determines whether to continue or to terminate the search. The
stopping variable in the asset selling problem takes the form of a reservation
price, i.e., a price above which each offer is accepted and under which each offer
is rejected. Search frameworks with so defined optimal search procedure are said to
posses the "reservation price property".199 Only this type of search procedures is
considered in the following analysis. The third question to be cleared is whether
the search always ends with a sale transaction for a finite reservation price. The
sale situation presented in section 2.2.1 sets an infinite time horizon for the
search process, which means that the seller is not bound to terminate the search at
some fixed deadline in the future. Does it, however, mean that under circumstances
the process may run infinitely? Under a finite reservation price receiving an
acceptable offer is not impossible as long as the at least one offer value at or
above the reservation price has a positive probability of occurrence. Thus, as long
as for each x in the domain of the assumed probability density function of offers
f(.) a y exists such that y>x and f(y)>0, there is a positive probability of an
acceptable offer for any (finite) reservation price. In this case, the probability
that the search will be successful (i.e., ends with a sale) approaches one when the
number of offers approaches infinity. The search will end almost certainly after a
finite number of offers. However, for some distribution functions not fulfilling
the above condition, the search process may never end if the reservation price is
set too high. The latter case is excluded from the following considerations. It
seems realistic to assume that there is al198

199

The proof has been brought by Chow/Robbins (1963). See also DeGroot (1970), pp.
278-293, Chow et al. (1971), pp. 41-61, and Ferguson (2000), pp. 3.1-3.9. The proof
of the optimality of reservation price based stopping rules utilizes the martingale
theory and is presented in DeGroot (1970), pp.278-289, or McCall (1965), pp. 310-
312. The reservation price property holds, when the distribution of offers is known
and has a finite second moment, as shown in DeGroot (1968), p. 108, Lippman/McCall
(1976a), pp. 158-159, Rosenfield/Shapiro (1981), pp. 2-3, or Rosenfield et al.
(1983), p. 1052. For the discussion of the reservation price property when the
offer distribution is unknown see Karni/Schwartz (1977), pp. 45-48.
116

Chapter 2: Search in Illiquid Markets

ways at least a slight chance of meeting some (irrational) individual ready to pay
an extremely high price. In this case, accomplishing the sale is only a question of
time independent of the reservation price.200 2.2.3. Basic Search Model

The simplest model of the market for illiquid assets is one with observation costs
only.201 The consequence of the lack of opportunity costs is that the value of
money remains unchanged in time and no discounting is necessary. This assumption is
rather rarely fulfilled in reality. One case when it may approximate a true sale
situation is when the search process can be performed relatively quickly. After
receiving an offer the seller has to choose whether to accept or to reject it.
Acceptance means receiving the offered price, rejection means continuing the
search. In order to choose the economically superior of these two options, their
values need to be compared. The value of the first one is simply the price offered.
The value of the further search is more difficult to determine; it is denoted as V.
Since the seller always chooses the more valuable alternative, her net receipts
(gain) from the decision on an offer Pi are defined as:202

G i = max[Pi , Vi ]
with: Gi Vi - net receipts from the decision on offer i - value of further search
if offer i is rejected

(2.1)

It is straightforward that in order to maximize the receipts from the sale, an


offer Pi should be accepted only if it exceeds Vi. Hence, the optimal reservation
price is equal to the value of further search. Finding the optimal reservation
price is, thus, reduced to the calculation of the corresponding search value.

200

201

202

The problem of the finiteness of search is more complex if one assumes that the
searcher does not know the distribution of prices. The proof that also in this case
the search ends after a finite number of offers is presented in Rothschild (1974a),
pp. 699-701. The model presented in this section is based mainly on MacQueen/Miller
(1960) and Lippman/McCall (1979), pp. 2-6. This type of search framework is,
however, the most often analyzed one and is referred to in most search theoretical
publications. See Stigler (1961), DeGroot (1968), Kohn/Shavell (1974), or Gastwirth
(1976). See MacQueen/Miller (1960), p. 364. For the derivation of the basic model
see also McCall (1970), pp. 115-117, Lippman/McCall (1979), pp. 2-6, and Ferguson
(2000), pp. 4.2-4.4.
2.2 Introduction to Search Models

117 (2.2)

p *i = Vi
with: p*i - reservation price for offer i

Since the time horizon of the seller is infinite, it is not possible to analyze
reservation prices for each period separately. Only a general rule for determining
their values can be derived in this case.203 The assumptions that the world is
static and that all offers come from the same probability distribution are helpful
at this point. They result in the seller being confronted with exactly the same
problem at each stage of the search. It doesn't matter whether she decides on the
1st or the 100th offer; the future outlook remains constant. Since the past offers
are lost in the considered framework, they are not relevant for the decision. This
means that the problem is invariant in time (myopic) and that the optimal search
policy can be determined by analyzing a single representative period. The optimal
decision rule for some offer i is then optimal for any other offer as well, and the
same reservation price should be applied during the whole search process.204 p *i =
p * for all i (2.3)

The value of further search in period i for a risk-indifferent investor is equal to


the expected net receipts achieved when she continues according to the assumed
strategy (Ei(G)). Due to the time-indifference of the problem, also the expected
receipts from future search are constant during the whole search. For simplicity
they are denoted as E(G): Vi = E i (G) = E(G) with: E(.) for all i (2.4)

- expectation operator

E(G) is computed from the definition of the expected value as an integral over all
possible outcomes weighted with their probabilities.205

203

204 205

The analytical derivation of optimal reservation prices in the infinite horizon


case is possible only for certain cases including the myopic one. No general
solution exists. Attempts have been made to derive approximate solution (see, e.g.,
Khne/Rschendorf, 2000 a, b). This problem is less severe if the search horizon is
limited; see section 2.3.3.1. See DeGroot (1970), pp. 376-377, or Ferguson (2000),
pp. 4.2. The value of search is typically derived in the literature using the
iterative approach presented later in this section. Mok (2002a), pp. 8-9, and Mok
(2002b), pp. 4-5, use a method similar to the one applied here.
118 E (G ) =

Chapter 2: Search in Illiquid Markets

g f (g) dg = g dF(g)
-

(2.5)

with: f(.)

- probability density function

Net receipts from sale in the period i depend on the value of the received
acceptable price offer and on the total search cost incurred up to this point:
G i = Pi - i c

(2.6)

For the considered case, the probability of selling at a certain price pi composes
of three terms: the probability of receiving an offer pi provided it is higher than
p*, the probability of receiving an offer higher than p*, and the probability that
all former offers were lower than p*. The second term ensures that the ith offer is
acceptable and the third term ensures that the process comes as far as to the ith
offer. Applying this to the equation (2.5) yields:

E(G) =

(pi - i c) Pr(Pi = p i Pi > p *) Pr(Pi > p*) Pr(Pj < p*) dp i i =1 j=1
-

i -1

(2.7)

with: Pr(.) Pr(.|.)

- probability - conditional probability

Because all offers have the same probability distribution, the probability of any
offer being under or above the reservation price is constant end equals to F(p*)
and (1F(p*)), respectively, where F(.) is the cumulative offer distribution
function (c.d.f.). Also the conditional expected value of an offer, provided that
it exceeds p*, is constant and defined as follows:

E(P P > p*) = E(Pi Pi > p*) = p Pr(Pi = p P > p *) dp =


-
p*

p dF(p)
1 - F(p*)
(2.8)

Hence, the equation (2.7) can be rewritten as follows:


2.2 Introduction to Search Models

119

E (G ) = (E(P P > p*) - i c ) (1 - F(p*)) F(p*)i-1 =


i =1

= E (P P > p *) (1 - F(p*)) F(p*)i-1 - c (1 - F(p*)) i F(p*)i-1


i =1 i =1

(2.9)

Noticing that the sums in this formula are sums of infinite geometric series allows
further simplification:
E(G) = E(P P > p*) - c 1 - F(p*)

(2.10)

The value of search is simply the expected value of an offer under the condition
that it exceeds the reservation price less the expected costs incurred during the
search. The result in (2.10) can also be achieved by following an iterative
approach, which is most common in the literature and may be helpful in
understanding the logic of the search model. Instead of considering all future
stages of the search, one may look only one period ahead and "pretend" that the
searcher has only an option to terminate the search immediately or to move to the
next period.206 In this case, the value of search can be regarded as the expected
result of two events: the value of the next offer if it is accepted and the
expected gain in the next period if the offer is rejected. Because of the time
invariability of the problem, the value of search is the same in all periods, and
so are the expected net receipts. The observation cost of c for the current period
is borne in any case. In effect, the following relation results:207

E(G ) = E(P P > p*) (1 - F(p*)) + E(G ) F(p*) - c


Transformation and simplification leads to the equation (2.10).

(2.11)

Having received the simplified formula for E(G), optimization techniques can be
applied to find the value of p* for which the value of search is maximal. Since no
specific probability function of P has been defined, no closed form solution is
possible. However, also with a defined p.d.f., an explicit solution for p* is an
exception rather
206

207

A search problem that can be solved by looking only one stage ahead (i.e. is
myopic) is referred to as "the monotone case". This class of search problems was
defined by Chow/Robbins (1961). See also Chow et al. (1971), pp. 54-55, or Ferguson
(2000), pp.5.7-5.19. Equations of this type are often called "Bellman equations".
120

Chapter 2: Search in Illiquid Markets

than a rule. Yet, this is not a serious practical problem as the precision achieved
with numerical optimization techniques is very high even when applied on a common
personal computer. The application of these methods allows finding a local maximum;
however, it does not assure that this maximum is a global one at the same time. The
certainty that the result is correct is given only when a single maximum (local and
global) exists. Fortunately, this is always the case for the basic model
independent on the p.d.f. of offers. A brief proof is presented below.208 It
follows from the equations (2.2), (2.3), and (2.4) that the optimal reservation
price is equal to the search value, i.e., p* = V. Substituting this in the equation
(2.10) and additionally substituting for E(P | P>p*) using (2.8) yields:

p* =

p*

p dF(p) - c
1 - F(p*)
(2.12)

Further rearrangement yields:209

p*

(p - p*) dF(p) = c

(2.13)

The left-hand-side term in this equation approaches infinity for small values of
p*, approaches zero for large values of p*, and is strictly decreasing210. Since
the right hand-side is constant, a unique root exists if c is positive; otherwise
the equation has no solution.211 This means that E(G) as defined in equation (2.10)
has a single maximum value with respect to p*. Finding any value of p* maximizing
the expected gain locally is equivalent to finding the absolute maximum of E(G).
This fact ensures that

208

209

210

211

See McCall (1970), pp.117-119, Lippman/McCall (1976a), pp. 159-161, or


Lippman/McCall (1979), pp. 3-4. The same result can be achieved by deriving (2.10)
with respect to p* and setting it equal to zero as the necessary condition for the
existence of extreme value. The derivate of the expression on the left-hand-side of
the equation is (F(p*)-1), which is negative (or at least non-positive) for all p*.
It follows that the whole right hand-side term is strictly decreasing. If the
seller is able to search "unpunished" as long as she wishes, she would choose an
infinitely high reservation price expecting an infinitely high return. The search
would last infinitely long in this case.
2.2 Introduction to Search Models

121

the application of numerical computer algorithms to calculate the optimal


reservation price will provide correct results. The equation (2.13), apart from its
convenience in proving the existence of a unique optimal reservation price, has
also an appealing economic interpretation. Its right hand side can be interpreted
as the value by which the next offer is expected to exceed the reservation price.
In other words, this is the marginal revenue expected when the search is continued
for one more period. In the optimal case, this marginal revenue should be equal to
the marginal cost of continuing the search for one more period, that is, the cost
of observing one more offer. This is in accordance with the general economic theory
the expected surplus receipts from one more search should be equal to the
additional cost accrued when it is conducted. The reservation price satisfying this
equation is the optimal one.212 2.2.4. Karlin's Model

The next model, like the previous one, utilizes the search theory to analyze the
sale of an illiquid asset. It ignores, however, the observation costs allowing for
discounting instead. The stress is mainly on the time aspect and on the opportunity
costs of search. Fixed search costs are treated as negligible and are omitted. The
model was presented by Karlin (1962) for the first time and generalized by McCall
(1965). Considerations regarding the optimal reservation price from the former
section are also valid for this model. When deciding on the acceptance or rejection
of an offer, a rational, wealth maximizing investor will always choose the higher
of two values: the offered price and the value of further search. It follows that
the optimal reservation price is equal to the value of further search. However, in
this model, the value of money is not constant over time. An investor is therefore
concerned about the present value of future cash-flows rather than their nominal
values. This means that possible future payments need to be discounted with the
factor in order to compare them with the current offer. Analogue to (2.2) and
considering (2.4), the reservation price equals the discounted expected gain from
further search: pi * = Vi = E i (G) (2.14)

212

See McCall (1970), p. 117, or Lippman/McCall (1979), p. 4.


122

Chapter 2: Search in Illiquid Markets

If the investor rejects an offer and moves on to the next period, the base period
of the discounting procedure changes as well. The choice of the optimal reservation
price is then made on the basis of the discounted value of further search from the
new point of view. So, the situation of the seller remains the same in all nodes of
the search. Like in the former model, the search problem is time invariant. From
this, it follows that the reservation price and the expected net receipts remain
constant. The equation (2.14) can be rewritten as follows:
p* = E(G)

(2.15)

Receipts from a successful sale in a period i are defined as:


G i = i Pi

(2.16)

Considering that all offers are identically distributed and (2.8) is also valid for
this model, the value of search can be computed as follows:
i -1 p i-1 Pr(P = p P > p *) Pr(P > p*) Pr(P < p*) dp = j i i i i i i i
=1 - j=1 i >1

E (G ) =

(2.17)

= i-1 E(P P > p *) (1 - F(p*)) F(p*)i-1


i =1

Since the final expression in (2.17) is an infinite geometric series, the equation
can be simplified to:
E (G ) = E ( P P > p*) (1 - F( p*) ) 1 - F( p*) = 1 p dF( p) 1 - F( p*) p*

(2.18)

Another way to derive this equation is by using an iterative approach analogue to


(2.11). The value of search in each period is composed of the expected receipts
resulting from the acceptance of the next offer and of the present value of further
search if the next offer is rejected:213

E (G ) = E(P P > p*) (1 - F(p*)) + E(G ) F(p*)


213

(2.19)
The iterative derivation was used by Karlin (1962).
2.3 The Real Estate Search Model Solving (2.19) with respect to E(G) yields (2.18).

123

The optimal reservation price for a risk-indifferent seller can be calculated from
(2.18) by maximizing the search value. However, also in this model it is generally
only possible by applying numerical techniques, what makes it necessary to prove
that there is a unique solution for the optimal p*. Substituting for E(G) in (2.18)
according to equations (2.15) yields after rearrangement:

p* - p * F( p*) - p dF(p) = 0 p*

(2.20)

It can be proved that, provided <1, the derivative of the expression on the left
handside of the above equation is strictly positive (the expression is increasing).
The expression is also negative for small values of p* and positive for large
values of p*. Thus, it is straightforward that a unique root to (2.18) exists and
that E(G) possesses a single maximum.214 Karlin's model demonstrates how sequential
search can be optimized under opportunity costs. Like the former model with
observation costs, it provides a method to specify the optimal reservation price
and the proof that a unique solution to the problem exists. A possibly serious and
so far unsolved problem with Karlin's model is that the sequential search strategy
does not necessarily need to be optimal in this case. If the observation costs are
low compared to the discounting effects, a fixed sample strategy, which allows
viewing multiple observations in one period, may be more cost-effective than the
time-consuming sequential search.215

2.3.

The Real Estate Search Model

Search models presented in the former sections served as an introduction of this


analysis tool. Basing on these concepts, a search theoretical approach is developed
in this section to model problems arising during the liquidation process of direct
real estate investments. The use of search models in this field is not new and has
been discussed a number of times in the literature.216 Most papers, however, refer
only indirectly to the
214 215 216

For a formal proof see Appendix A.1. See Morgan (1983). See Courant (1978), Cronin
(1982), Glower et al. (1998), Balvers (1990), or Arnold (1999).
124

Chapter 2: Search in Illiquid Markets

problem of liquidity concentrating rather on various aspects of market operation.


In the following sections, the standard search models are adjusted to include
certain aspects of property markets, which are especially relevant in the context
of their limited marketability. The resulting real estate search model constitutes
the basis for the analysis in the following chapters. One of the main dilemmas
encountered when constructing a search model, and actually any specific model, is
the choice between realism and practical applicability. The first goal requires
that subtle interdependencies between model variables and processes occurring in
real markets are accounted for. The second goal requires directly observable input
variables and robust methods of analysis, which are insensitive to possible
misspecifications and observation errors. Unfortunately, these two goals are to a
large extent mutually exclusive. Enhancing the model with more realistic features
leads inevitably to an increase in complexity that makes the specification of
parameter values on the basis of easily available data very difficult. Because
practical relevance of the results is one of the main aspirations of this work,
simplicity has been chosen as the general principle of model construction in this
Chapter. The objective was to include only as many variables as were absolutely
necessary to allow for the key aspects of liquidity in real estate markets. It
should also be possible to estimate model parameters only on the basis of data
available to professional investors. As a result, some less important aspects of
the search process, which may play some role in reality, have been omitted. This is
the main source of the model's major limitations, which are discussed at the end of
the section. Also several possible extensions are outlined, but the issue of their
full implementation is left open for further research. 2.3.1. Framework
Modifications

The real estate sale framework is based on the standard search framework from
section 2.2.1. The abstract "asset" is now specified as a real estate property, but
its key characteristics remain the same. It is assumed that the seller considers it
as a financial investment, i.e., does not inhabit it and is only concerned about
the selling price ignoring other characteristics of prospective buyers. Offers
arrive sequentially and are accepted or rejected on the basis of the reservation
price. The seller operates in an infinite horizon framework in which recalls of
past offers are not allowed. Unlike in the discussed basic models, search costs
including observation and opportunity costs are allowed for simultaneously. This
framework is further extended with a number of additional as-
2.3 The Real Estate Search Model

125

sumptions concerning, in particular, the distribution of offers, rental revenues,


market fluctuations, and continuous time. Since they require a more detailed
discussion, separate sections are devoted to each of them.

2.3.1.1. Distribution of Offers


In the ideal case, the distribution of offers in the model should be based on the
real one adequate for the studied market. However, since in most cases the real
distribution either cannot be precisely assessed or it has a very complex
mathematical form, an acceptable approximation is the only practicable solution.
Like in many economic issues, the Gaussian normal distribution is the first and
most natural choice. The probability of receiving an offer p and an offer lower
than p when offers are normally distributed is determined by the following
probability density function (p.d.f.) and cumulative distribution function
(c.d.f.), respectively:

1 f (p) = e ~ 2

-( p - )2 22 -( x - )2 2 2

(2.21)

1 F(p) = e ~ 2 -
with: ~

dx

- expected value of P, - standard deviation of P, - pi-constant217.

These functions can by alternatively denoted using the standard normal


distribution:
1 p- 1 e f (p) = = ~ 2 1 p- F(p) = = e ~ 2 -
p -( p - )2 22 p - -

-( x - )2 22

(2.22) e
-x 2 2

dx =

1 ~ 2

dx

with: (.) (.)

- p.d.f. of the standard normal distribution, - c.d.f. of the standard normal


distribution.

217
~ is used to denote the pi-constant (3.1415...) in order to avoid confusion with
the relative price variable used later on in this chapter.
126

Chapter 2: Search in Illiquid Markets

A useful feature of the normal distribution is the irrelevance of its higher


moments. The distribution is fully determined by only two parameters: the mean and
the standard deviation; other moments, including the skewness and kurtosis, are
constant. This characteristic simplifies mathematical applications in many cases;
only two parameters need to be analyzed. They also have intuitive economic
interpretations. With respect to the value of a property, can be viewed as the
average valuation by market participants or the price level on the market, and can
be interpreted as the divergence of opinions about the value of the house. Since
property prices are never negative, one could argue that normal distribution (at
least in its left tail) cannot comply with the true distribution of offers, and a
rightskewed distribution with non-negative values would provide a better fit. Yet,
there are at least two arguments to still support the use of the normal
distribution. Firstly, in the vast majority of cases, real estate prices are far
away from the zero mark, and for higher values many skewed distributions, like the
lognormal, t-Student, or 2, can be approximated by the normal one. Secondly, what
actually stands behind the distribution of offers are not prices but opinions about
the value of a property, which by all means can be negative. One can easily imagine
that someone would accept a house only if she's paid for it. This would be the
case, for example, when the personal situation of the individual wouldn't allow her
to use (or rent) the house in any way, but she would be forces to carry the
maintenance costs and taxes associated with it. Of course, negative prices are
never observed in reality; it doesn't mean, however, that there are no negative
appraisals by some market participants. In this sense, a positive probability of
receiving a negative offer from the left tail of the distribution means meeting a
potential buyer who would accept the burden of owing the property only against an
appropriate compensation.

2.3.1.2. Continuous Time


One of the key aspects of trading illiquid assets is time. Since the search
procedure is time consuming this aspect is also present in most search models. The
duration of search in the basic models is equivalent to the number of reviewed
offers and deter-
2.3 The Real Estate Search Model

127

mined by the reservation price the expected duration of search (D) is simply the
reciprocal of the probability that an acceptable offer arrives:218
E ( D) = 1 1 - F(p*)

(2.23)

However, the equivalence between the number of offers and the duration of search is
given only for fixed and identical time intervals between offers (t) as they were
assumed in the original search framework. The expected time until sale is then
tE(D). This approach is easy to handle but not very realistic. Random offer
arrival times are much closer to the true sale situation.219 They also comply
better with the nature of the time aspect of liquidity. A standard approach to
modeling stochastic arrival processes is the assumption of a Poisson process. The
numbers of events (offer arrivals) in any two non-overlapping intervals are
independent and no simultaneous events are possible in this process. Its
characteristic feature is the lack of "memory" the probability of the next event
occurring within a given time span is independent of when the last event occurred.
In other words, the probability of receiving an offer does not depend on the time
elapsed since the rejections of the last offer. This approach is adequate when
describing the arrival of offers in markets with independent buyers. However, if
buyers' independency is not given, the assumption of the Poisson process becomes
problematic. This can be the case in very narrow markets with only few potential
buyers. It is then possible that all offers are placed simultaneously, so that no
real "offer flow" takes place. Also extensive marketing actions undertaken before
or during the liquidation may distort the independency of offer arrivals. The
realism of the model may be limited in such cases. Within a Poisson process, the
Poisson probability function describes the number of events occurring during a
fixed period, and the exponential probability function describes the time between
two subsequent events. Thus, the latter one can be used to
218

The expected duration of search is, in fact, equal to the expected value of a
geometric distribution and can be computing directly from its definition:
E ( D) = i (1 - F( p*) ) F(p*) i -1
i =1

219

Search models with random intervals between offers are often referred to as
"continues time models" as opposed to "discrete time models". They are used by
Karlin (1962), pp. 151-153, or McCall (1965), pp. 308 ff.
128

Chapter 2: Search in Illiquid Markets

describe intervals between subsequent offers (T1, T2, T3 etc.). Since they are
independent and identically distributed, they can also be treated as realizations
of a random variable T. Its p.d.f. is defined as follows:
f ( t ) = e - t

(2.24)

The parameter in this formula represents the "intensity" of offer flow. It can be
interpreted as the number of offers expected in a unit of time (e.g., one year). On
the other hand, the reciprocal of is the expected time between two subsequent
offers. The assumption of random offer arrival times affects all time-dependent
variables in the model, in particular, the discounting factors, rental revenues,
and market changes. Note that the unit of should be identical with the base time
unit of these variables.

2.3.1.3. Opportunity Cost and Discounting


A discounting factor has been already introduced in the Karlin's model. Its main
function remains the same in the real estate search model it is used to discount
future payments in order to determine their present value. The discounting effect
depends on the discount rate and on the discounting period t. It is calculated in
the continuous time framework as:

= e -t

(2.25)

As a consequence of random time intervals introduced in the former section also the
discounting factor is random. Its expected value is:220

E () = e -t e -t dt =
0

(2.26)

From the economic point of view, the (non-random) discounting rate imbedded in the
discounting factor represents opportunity costs, i.e., the costs of delaying the
sale for one period. In finance, is usually equivalent to the profitability of the
second best use of the capital bounded in the analyzed investment project. This can
be the profitability of an alternative investment or the financing cost. This is
also the sense of the discounting rate in the search model. One the one hand, as
long as the property remains
220

See Lippman/McCall (1976a), pp.164-165.


2.3 The Real Estate Search Model

129

unsold, the investor cannot use the bounded capital for other purposes and looses
the potential interest. On the other hand, if the sale proceeds are to be used for
debt repayment, penalty interest has to be paid or additional costs of financial
bridging arise when the sale is delayed. It is hereby assumed that financing
facilities are always available at the same conditions, i.e., failing to sell
within some time horizon does not affect the overall financial standing of the
investor. Note that the above traditional notion of opportunity cost is valid only
if a planned liquidation is considered. It can be assumed then that the investor is
prepared for the eventuality of a long search and sufficient financing is secured.
As discussed in the Chapter 1 in section 1.4.2.2, this is the largely unproblematic
case. The lack of perfect liquidity becomes much more disturbing when a liquidity
bottleneck arises suddenly. When the sale is forced by unforeseen circumstances, it
is rather improbable that sufficient funds are available at normal conditions.
Beside the extremely high emergency crediting costs, which are very likely in such
case, not completing the sale quickly may also have other severe consequences such
as the deterioration of credit rating, loss of independency, or even bankruptcy.
Since these are the true costs of delaying the sale, they should be used for
discounting. However, determination of appropriate values may prove very difficult
in this case and require an individual analysis of investor's situation in an
"emergency" event.

2.3.1.4. Rental Revenues


One of the main features of property investments is the twofold source of returns:
they came from value appreciations and from rental revenues. This allows treating
real estate as a combination of equity and debt221 and should be accounted for when
modeling liquidation of property investments. On the one hand, an investor attempts
to realize the best achievable price sale means the flow of funds corresponding
with the accepted offer. On the other hand, as long as the property remains unsold,
she receives the monthly rent sale means in this context the cease of the income
cash flow. The analogue situation arises at the purchase of real estate: sale means
paying the price, but also starting to receive the rental income. The easiest way
to implement rental revenues (denoted as h) is by combining them with observation
costs. It requires the assumption that rent payment periods coincide
221

See Booth et al. (1989) or Jandura (2003), 28 ff.


130

Chapter 2: Search in Illiquid Markets

with offer arrival times. But even if no perfect coincidence is given, it is always
possible to split the payments and attach them to the respective offers without
incurring major errors. It is also theoretically conceivable to consider these
factors separately, but it would lead, at least for certain subperiods, to the loss
of model's time invariance and unnecessary complicate the analysis. Since a
practicable approach should be kept as simple as possible, it is assumed that each
offer arrival is associated with a net payment of (h-c). In most cases of real
estate investments, pure observation costs are very small compared to other amounts
involved. The cost of making a house available for visitation or placing an
advertisement in a newspaper is practically near to zero. The costs of employing a
broker who organizes visitations and reviews the offers may be slightly higher.
However, since the brokerage commission is usually calculated as a percentage of
the sale price, it is easier and more precise to consider them together with other
transaction costs and make respective corrections of offer values. Altogether,
observation costs during the search for a buyer may be treated as negligible in the
real estate case allowing for further simplification.222 Recapitulating, for the
sake of simplicity the observation cost c is ignored in the following
considerations. Only the rental revenue h is allowed for as a "negative observation
cost". A slight problem with the coincidence between rent payment periods and offer
arrival times arises when the latter are assumed random. In order to retain the
assumption that the rent is payable each time a new offer is received, variable,
time dependent rental revenues need to be introduced. This is done by redefining h
as a periodical (e.g., monthly or annual) rental rate, which is multiplied with the
length of the time interval to determine the rent due at the moment of an offer
arrival. Thus, hTi stands for the rent received between the (i-1)th and ith offer.
This approach still leads to a slight bias since the capitalization of an
irregularly incurred cash flow does not yield exactly the same result as the
capitalization of payments made in fixed time intervals. However, errors generated
by this effect should be relatively small in the typical case.

222

However, one needs to bear in mind that this may not hold for the search for a
buyer since the assessment of offers requires a separate appraisal of each
property, which may proof costly.
2.3 The Real Estate Search Model

131

2.3.1.5. Market Uncertainty


Up to this point the market has been assumed stable in the sense that the
distribution of arriving offers remained unchanged over time. Yet, the possibility
of market changes during the search constitutes an important factor in the
liquidity analysis; it is one of the main sources of liquidity risk formulated in
section 1.2.2.3. There are numerous possibilities how market uncertainty can be
introduced in the search problem. A relatively simple approach based on a linear
trend with random distortions is presented here. Some more sophisticated
alternatives are discussed in section 2.3.3.2. A deterministic linear market trend
of is assumed.223 On the one hand, it affects the valuation of the property by
each market participant in the same manner a shift in the whole offer
distribution results. On the other hand, it also applies to the rental income. The
fact that both prices and rents are subject to changes at the same rate allows an
easy implementation of the trend in the model by adjusting the discounting factor .
Since the discount rate and the trend rate affect the (present) value of future
payments, their effects, despite different directions, are similar. The trend-
corrected discounting factor is thus: ~ = e t e -t = e -(-)t (2.27)

Along with the deterministic trend random, deviations are allowed for with respect
to property prices, or more specifically, to the distribution of offers. They are
interpreted as unexpected fluctuations of the real estate market between offer
arrivals, which drive the price level away from its expected path. Although these
deviations can be modeled as a series of random, independent variables, it is more
convenient to capture the total effect within one variable referring to the moment
of sale; it is denoted as A and referred to as "market uncertainty". The effect of
A on the offer distribution is assumed to depend linearly on the time until sale
and is captured with the factor (1+AT). The compound rather than the (otherwise
common) continuous time calculation has been chosen at this point for easier model
calculations. Given the sale at the ith offer, the combination of the deterministic
trend with the random deviation results in the following total change of the price
level:

223

Search models with trend are often applied in the valuation of financial options.
See Jacka (1991) or Beibel/Lerche (1997).
132
Pi = P (1 + A Tj ) e
j=1 i - Tj
j=1 i

Chapter 2: Search in Illiquid Markets

(2.28)

The deviations from the trend occurring between offers and, consequently, the
market uncertainty factor A are assumed to have the expected value of 0. This means
that the seller expects the price level to follow the general trend. However, she
is not certain whether this expectation will come true. The level of this
uncertainty can be expressed as the standard deviation of A (A). The deviations
from the trend are assumed to be known immediately as they occur. Thus, the seller
always knows the current distribution of offers when setting the reservation price
in each period including all expected and unexpected changes up to that time. Note
that random fluctuations affect only the price but not the rental income, which
strictly follows the deterministic trend. This approach seems to comply with
reality. Properties are usually appraised on the basis of discounted future cash
flows;224 it is therefore plausible that prices and rents change approximately at
the same rate in the long run.225 In the short term, however, rental revenues
should be much less volatile than property prices. The latter can be subject to
sudden changes resulting from economic shocks (e.g., stock market turmoils may lead
to the flight of funds into real estate) or legal changes (e.g., new tax
regulations). Furthermore, the price level can also be influenced by more or less
random fluctuations in the supply and demand or by changes in the attitude of users
to certain types of properties. On the other hand, a stable increase of rents in
place is often secured by appropriate indexing clauses in lease contracts as well
as long durations of the leases.226 To sum up, it is rather improbable that the
income from the running leases would vary in response to random short-term market
fluctuations, like property prices do, but it is quite probable that it would be
steadily adjusted according to an indexing clause, which reflects the expected
trend. The variability of rents can therefore be neglected.

224

225

226

On the income approach to real estate appraisal see Appraisal Institute (2001),
Chapter 20, or TEGoVA (2003), Appendix 1. A practically important advantage of the
assumption that prices and rents follow the same trend is the preservation of the
myopic property of the model. Note that the stable increase of rents due to
indexing refers only to the existing rental contracts; new lettings are made on the
basis of the current market situation. However, only the former case is relevant in
the considered liquidation framework.
2.3 The Real Estate Search Model

133

Nevertheless, the use of the uncertainty parameter A to model market uncertainty is


not entirely unproblematic. Assuming that only unexpected events cause departures
from the trend (information efficiency thesis227) allows treating price changes in
terms of a stochastic process. Modern capital market theories demand that such
price processes have certain properties if a long-term equilibrium is to be
preserved; in particular, they should follow a random walk. However, the assumption
about the expected value of the deviations from the trend being equal to 0 turns
out to be inconsistent with the random walk hypothesis. The information efficiency
thesis implies that assets' returns in subsequent periods are independent, that is,
price movements are not influenced by the past. If returns are also assumed to be
identically distributed than, according to the central limit theorem, compound
returns over longer periods follow a random walk and are asymptotically normally
distributed. Since the convergence to the Gaussian curve is very quick, normal
distribution can be assumed for continuous returns (rc). This results in a
logarithmic normal (lognormal) distribution of discrete returns (rd).228 rc = ln(e
rc ) = ln(1 + rd ) ~ N( r , r ) with: r - expected value of continuous returns r
- standard deviation of continuous returns N(.) - normal distribution operator
(2.29)

In consequence, the expected price change is given as:


E(1 + rd ) = e r + r
2

(2.30)

which is larger than 1 for any non-negative r. So, even if the market was stable
in terms of a zero expected (continuous) return, market prices would follow an
increasing trend.229

227

228

229

In general, a market is efficient if all information that influences the value of


an asset is reflected in its market price immediately as it occurs. Depending on
the type of information the literature differentiates between weak, semistrong and
strong form of efficiency. See Fama (1970), Levy/Sarnat (1984), Chapter 19, or
Elton et al. (2003), Chapter 17, as well as the literature cited there. For a
review of the stochastic properties of market prices see Osborne (1959) or Fama
(1965), as well as a number of papers reprinted in Cootner (1964). The source of
this effect is the asymmetry of upward and downward market changes in the discrete
approach. An increase of x% and a subsequent decrease of x% do not lead to the
initial value. E.g.,
134

Chapter 2: Search in Illiquid Markets

Applying the above logic to the search model leads to the conclusion that the
expected deviation from the trend E(A) = 0 implies in fact an expected continuous
trend of less than . To demonstrate it, denote the continuous deviation from the
trend as . If price fluctuations around the trend where independent and
identically distributed than A and should be lognormally and normally
distributed, respectively. In analogy to (2.30), the expected effect on the price
level in the time period T would be then given as:

E (1 + A T) e T = E(1 + A T) e T = e TE(A )+T

~ V ( A ) 2

e T

(2.31)

Note that E(1+AT) = 1, and consequently E(A) = 0, only if E() = - T2V()/2 < 0.
Thus, the expected discrete deviation from the trend is zero only if the expected
continuous deviation is negative. The latter leads in the long run to a negative
drift away from the assumed trend the actual trend rate is then less than . An
adjustment of the market trend is a possible solution to the above problem. One
could compensate for the above distortion by increasing by T2V()/2. A drawback
of this approach is, however, that the adjusted trend is also applied to rents, so
that the source of the error is shifted from the price to the rental component.
Another solution is to assume A to be normally (instead of lognormally) distributed
accepting the resulting inaccuracy. This approach seems to be more appropriate for
modeling real estate liquidity. The reason is twofold: Firstly, the lognormal
distribution can be often well approximated by the normal one; simulations have
shown that in most cases differences between price paths resulting from sequences
of discrete market changes generated from a normal and a lognormal distribution
become practically relevant only after several hundreds or even thousands of
periods. It is rather improbable that any search in a real estate market would take
so long. Secondly, the thesis of normally distributed continuous returns is
controversial even for publicly traded, highly liquid stocks;230 it is even more so
for real estate returns. Empirical studies in the USA, UK, Germany, and Australia
found evidence of leptokurtosis and asymmetry (skewness) in the distributions of
property returns in these countries. The results were significant enough to re-

230

starting with the price level of 1 a sequence of market changes -10% and +10%
result in 10,91,1 = 0,99 < 1. This asymmetry does not occur in the continuous
approach due to the logarithm; subsequent returns offset each other (e10%-10% = 1).
See Mandelbrot (1963, 1967), Fama (1965), Clark (1973), and more recently
Chunhachinda et al. (1997), Rehkugler et al. (1999), pp. 157-160, Aparicio/Estrada
(2001), or Harris/Kkzmen (2001).
2.3 The Real Estate Search Model

135

ject the normality hypothesis.231 Thus, most probably, errors could not have been
avoided even with a random walk conform approach. Therefore, discrete price changes
in the search model are assumed to be normally distributed. Due to the good
approximation of the lognormal distribution by the normal one for realistic
durations of the search process, the resulting bias should be acceptably low.

2.3.1.6. The Relative Approach


A serious practical problem with the traditional search models is that they operate
on absolute variable values. Specification of model parameters necessary for its
practical application may then turn out to be a difficult forecasting problem.
Especially, if liquidity is to be allowed for in investment decisions, the
respective analysis needs to be accomplished long before the sale process begins,
and possibly even before the asset is purchased. Thus, the analysis of strategic
liquidation at the end of investment horizon, which is usually very long term for
real estate, requires the prediction of the market situation many years ahead; the
quality of such forecasts is usually very low. The problem becomes even more severe
in the case of an unexpected liquidation. Without the knowledge of the presumed
timing of the liquidation, a forecast becomes practically impossible. In order to
mitigate the above problem, it is advantageous to redefine the model in a way in
which it relies as little as possible on precise predictions of the future. The
most straightforward way is to use relative rather than absolute variable values.
The state of the market at the beginning of the search, measured as the average
valuation of the asset or the expected value of the offer distribution (), is a
reasonable reference point for this purpose. Thus, model variables in the relative
approach are computed by relating the original ones to : , *= p*/ = G/
231

- relative price offer, - relative reservation price, - relative net receipts from
sale,

See Miles/McCue (1984), Myer/Webb (1993), or Young/Graff (1995) for studies of the
real estate returns distribution on the U.S. market, Maurer et al. (2004) for the
English and German, Morawski/Rehkugler (2006) for the German market, and Graff et
al. (1997) for the Australian market. See Morawski/Rehkugler (2006), p. 21-22, for
a review of research on the normality of real estate returns.
136 = / = h/ - volatility coefficient of offers, - relative rent.

Chapter 2: Search in Illiquid Markets

The new variables in the model receive respectively new interpretations. Offers are
now quoted not as absolute values but as fractions of the average valuation by
potential buyers an offer of 1.1 means 10% above the average and an offer of 0.9
means 10% below the average. In consequence, the distribution of offers needs to be
redefined. The mean of the new "relative" distribution, with the c.d.f. denoted as
FR, is equal to 1 and the standard deviation is = /. The values of the relative
distribution function are, however, the same as the respective values of the
absolute distribution function, i.e., FR() = F(p). The assumption about the normal
distribution of offers in section 2.3.1.1 becomes especially advantageous at this
point. It is fully defined by the mean and the standard deviation. Since the mean
always equals 1 in the relative approach, only the standard deviation of the
relative offers matters. Thus, the relative heterogeneity of opinions among
potential buyers remains the only relevant parameter. With the new notion of an
offer, reservation prices and sale receipts also receive new interpretations they
are now expressed as fractions of the average valuation of the property. One of the
main practical advantages of the relative approach is higher stability of the main
model parameters. In the first place, relating all variables to the average market
valuation "neutralizes" the role of the price level for the results of the
analysis. This parameter, which was probably most difficult to forecast in the
absolute version of the search model, is now absent. Furthermore, it seems
plausible that the relative dispersion of opinions about the value of a property is
more stable than the absolute one. An argument in favor of this thesis is the
stability of the observed appraisal errors understood as percentage deviations of
appraisals from the subsequent transaction prices.232 Assuming that most real
estate investors obtain and follow such appraisals when buying or selling
properties, the dispersion of offers should also display a similar stability. Same
applies to the "relative rent", which can be interpreted as the ratio of the rental
revenue to the value of a property; it corresponds with the property's income
return.233 This parameter should to be also less volatile than the absolute rent.
Although it may
232 233

See, e.g., RICS (2005). For other illiquid assets, for which observation costs are
not negligible, this parameter would take the form of the "relative observation
cost" (h-c)/.
2.3 The Real Estate Search Model

137

fluctuate in the short term, one would expect that real estate rents and prices
should not go too far apart in the long run. This is due to the role of rents as
key value drivers of real estate; their long term increases or decreases must
result in respective (though possibly lagged) adjustments in property prices. The
only reason for a sustainable change of is a change in the fundamental
characteristics, especially the risk, of the considered property market. This,
however, is much less frequent than common market fluctuations. To sum up, the
relative approach seems to allow for more stability in the main model variables
and, thus, be less prone to estimation and forecasting errors. It also seems to be
more suitable for analyzing liquidity. By relating all variables in the model to
the average price level at the beginning of the liquidation process, the effects of
changes in the market situation, which may occure before the sale is initiated, are
disregarded. Thus, it does not matter where the market stands at the moment of the
liquidation; the only issue that matters is the relation of the net sale receipts
to the current average valuation of the property. 2.3.2. Model Design

The real estate sale model results as a combination of both basic models from
sections 2.2.3 and 2.2.4 modified according to the propositions in the previous
sections.234 The model analysis follows the same scheme as in the former sections.
Since many of the arising problems are similar to those already dealt with, the
presentation is abbreviated at these points. The present value of the net sale
receipts, provided that the sale was accopmlished at the ith offer, is composed of
the discounted accepted price after expected and unexpected market changes and the
sum of discounted rental revenues incurred so far:
i ~ ~ ~ -( - )Tj i = i (1 + A Ti ) e -(-)Ti + Tj e j=1
i ~ with: Ti = Tj j=1

(2.32)

- total search duration provided the ith offer is accepted

234

A similar, though not identical problem is dealt with by Lippman/McCall (1976a),


pp. 163-166, and Lippman/McCall (1986).
138

Chapter 2: Search in Illiquid Markets

Since the expected value of the market uncertainty factor is 0, i.e., the market is
ex ante not expected to depart from the long term trend, the seller is faced with
the same situation at each offer arrival. Also opportunity costs and rental
revenues do not allow distinguishing one period from another. The search problem
remains therefore time indifferent and the model retains its myopic property.
However, due to the possibility of a market change, the nature of the reservation
price is slightly different. At this point, the assumption that the seller knows
the current market situation when setting the reservation price in each period is
relevant. The past market development is then already known and the past market
uncertainty factors as well as time intervals are not random any more. Thus, the
reservation price can be defined as referring only to the "base offer" .235 The
acceptance condition can be denoted equivalently as > * and is identical with the
one in the former models. However, its meaning is now different and should be read
as: "accept any offer at or above *(1+a t )", with a and t being
~ the known realizations of A and T , respectively. Furthermore, the randomness of
offer ~ ~

arrival times requires that also the moment of receiving the first offer is
uncertain. Thus, the search is assumed to begin with the decision to sell the
first offer arrives after a random period of time T1. Given the c.d.f. of the
market uncertainty factor denoted as FA(.) and the c.d.f. of the time intervals
denoted as FT(.), which is exponential (i.e., FT(t) = e-t), the value of search is
analogue to (2.7) and (2.17) and given as follows:236
i ~ ~ ~ -( - )Tj = E () = E (1 + A Ti ) e -( -)Ti + Tj e j=1 i i
i i ( - ) t j ( - ) t kj j=1 j=1 ... ... i (1 + a t j ) e + tj e
j=1 i =1 - - 0 0 - j=1 i i Pr( i = i i > *) (1 - FR (*)) FR-1 (*) di dFT
( t j ) dFA (a ) j=1

(2.33)

235

236

Since the base offers have the same distribution in all periods, i.e. i are
independent and identically distributed for all i, they can be denoted as one
random variable . Note that the terms "search value" and "expected (relative) net
receipts" are used as synonyms throughout the analysis. They are also abbreviated
as "expected receipts" in some context. In all these cases, the expected value of
all discounted payments experienced by the investor during the liquidation (i.e.,
E()) is meant.
2.3 The Real Estate Search Model

139

The simplification of the integrals and sums in this formula is presented in


Appendix A.2. The same result can be achieved by utilizing model's myopic property
and following the iterative way of reasoning, as shown below. Nevertheless, the
"long" approach is still useful for the derivation of the conditions for the
existence of a finite solution as well as for the derivation of other statistical
parameters discussed in following chapters. The value of search (i.e., the expected
net receipts from sale) in period t results from the expected outcome of the
decision on the next offer and on the value of the further search. Thus:
E t ( ) ^ = E e -T(-) (1 + T A) E( > *) (1 - F(*)) + E t +1 () F(*) + T
(2.34)

with T and referring to the time interval and the market uncertainty effect in
one representative period, respectively. Since E() = 0 and T is exponentially
distributed, the expected value of is:

E t ( ) = E ( > *) (1 - F( *)) + E t +1 () F( *) + +- +- ( + - )2 (2.35)

Time invariance of the search problem requires that Et() = Et+1() = E().
Considering it yields after rearrangement:

E ( ) =

E( > *) (1 - FR (*)) + - + (1 - FR (*)) +-

(2.36)

The final step in the construction of the model is the implementation of the
assumption about the normal distribution of offers as defined in section 2.3.1.1.
It is accomplished by substituting the general c.d.f. FR(.) with the cumulative
normal distribution function FN(.) having the mean of 1 and the standard deviation
of :237

237

The analogue formula for the search model with observation cost can be found in
Gastwirth (1976), p. 76 or Feinberg/Johnson (1977), p. 1595. Also the solution for
the uniform offer distribution is derived there.
140

Chapter 2: Search in Illiquid Markets

E ( ) =

(1 - FN (*)) + 2 f N (*) + - + (1 - FN (*)) +-

(2.37)

The formula can be analogically rewritten in terms of the standard normal


distribution:

E ( ) =

* -1 * -1 1 - (2.38) + + * -1 +- - + 1 -

The reservation price maximizing the expected net receipts can be computed
numerically provided a unique solution exists. This was the case in both earlier
discussed models but only under certain conditions: c>0 (standard model with
observation costs) and <1 (Karlin's model). The second condition becomes now: < .
It is fulfilled only as long as the trend does not exceed the opportunity cost.
Otherwise future offers become more and more valuable with time, and infinite net
receipts are possible.238 The first condition takes the form of < 0. Since rental
revenues are positive, it is clearly never fulfilled in the real estate case.
However, it turns out that it is not necessary for the existence of a unique
solution in this framework. Since is subject to discounting, one can expect that
its influence on the value of search weakens as far future is considered. This can
be formally proved by analyzing the function (2.36). It reveals that E() is
increasing for small values of * and is decreasing for large *. Since E() is
continuous, it has always at least one maximum. Further analysis reveals that
independent of the distribution of offers only one maximum exists.239 The typical
plot of the expected net receipts as a function of the reservation price is
depicted in Figure 22: it takes the value of /(+-)(E() + /(+-)) for very low
reservation prices and the value of /(+-)(-) for very high reservation prices.
The former one is, in fact, the expected outcome of accepting the first incoming
offer and the latter one is the (discounted) value of infinite rental payments.
Hence, a single absolute maximum value exists.

238

239

This condition arises from the finiteness condition of integrals as well as


infinite sums occurring in the computation of the search value. See Appendix A.2.
An extensive proof of the existence of a single maximum of E() is brought in
Appendix A.3.
2.3 The Real Estate Search Model
1,4

141

1,2

Expected Net Receipts

0,8

0,6

0,4

0,2

0 0,0 0,2 0,4 0,6 0,8 1,0 1,2

*opt
1,4 1,6 1,8 2,0

Reservation Price

Figure 2-2: Determination of the optimal reservation price in the real estate
search model240

From the economic point of view, it is important that no economically pointless


behavior results from following the optimal strategy. Especially, it should be
ensured that the accepted selling price is not below the searcher's valuation of
the property. The individual valuation arises from the capitalized cash flows
generated by the investment; in the model setting, it corresponds with the sum of
discounted rental revenues. Recall from equations (2.2), (2.3), and (2.4) that the
reservation price maximizing the value of the search always equals the expected net
receipts from continuing the search. In the considered case, it means that * = E(|
*). Since the maximal value of E() cannot be smaller than the discounted infinite
annuity of rental payments, the same must be valid for *. Thus, the expected
receipts from holding the property infinitely long determine the lowest possible
reservation price. In other words, the reservation price always lies above seller's
valuation of the property. The formula (2.38) allows also analyzing the influence
of other model parameters on the expected receipts from search. In some cases the
effects are clear: an increase of the rent (income return) or the trend factor
leads to an increase of the expected re240

Following parameters were used: offer volatility () = 15%; trend () = 5%; rental
income () = 5%; discounting rate () = 15%; offer frequency () = 52.
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Chapter 2: Search in Illiquid Markets

ceipts, but an increase of the discount rate decreases E(). The effects of changes
in the dispersion of offers or in the offer frequency are, however, ambiguous and
depend on the values of other parameters. A higher increases the probability of
receiving extreme offers. Thus, for reservation prices above the average valuation
(*>1), the probability of receiving an acceptable offer increases with . One would
intuitively expect a higher expected sale price and a higher value of search in
this case. However, this effect may reverse in some situations. Since a (constant)
reservation price is easier to achieve with a higher , the search is completed more
quickly. This means smaller opportunity costs but also lower rental revenues. If
the rental income is high compared to the effective discount rate (i.e., discount
rate less trend), shortening the duration of the search may negatively affect the
total expected receipts. For reservation prices below the average valuation (*<1),
the probability of receiving an acceptable offer decreases with , so the effects of
changes in the dispersion of offers are unclear even with low rental income
rates.241 The impact of changes in the offer arrival rate is similarly ambiguous.
Without rental income, higher offer frequency leads to shorter search durations
reducing the discounting effects and, thus, increasing the expected value of the
receipts. However, if is high compared to (-), shortening the search may
negatively affect the expected gain.242 Summing up, the consequences of changes in
the model parameters are often results of complex interactions between variables,
and their final effects can only be evaluated in the context of a concrete
situation. 2.3.3. Limitations and Possible Extensions

As already noted before, the real estate search model presented here is the result
of a compromise between realism and practicability. The central idea was to design
a model that would capture the main features characterizing direct real estate
investments but remain simple enough to allow easy practical application. This led
inevitably to simplifications, which in certain circumstances may be considered as
going too far. They can refer to the characteristics of the analyzed markets (e.g.,
the regime of the price process), to the person of the investor or to the nature of
the search strategy. Still,
241

242

The effects of changes in the dispersion of the offer distribution are analyzed by
Venezia (1980) or Balvers (1990). They consider, however, the effect with the
simultaneous adjustment of the reservation price. At first glance, it may seem
startling that the level of market uncertainty does not affect E(). Since the
expectation about the value of this parameter is always zero, it does not occur in
the computation of the expected net receipts. In fact, only the volatility of A
(A), will play a role when the risk aspect of liquidation is considered in the
forthcoming chapters.
2.3 The Real Estate Search Model

143

many of these problems can be solved on the basis of the search framework by
applying respective adjustments to the model. In most cases, however, such
adjustments considerably increase the grade of model's complexity, require
additional assumptions about the relations between variables, or prevent a closed-
form analytical solution. Therefore, this section provides only an outline of
propositions how certain special features can be incorporated into the model; their
full implementation is beyond the scope of this work. For better tractability and
easier comparability with the literature, the basic search model with observation
costs is used as the reference point in most cases, but analogue results are valid
for any other type of search model including the real estate one.

2.3.3.1. Bounded Search Horizon


No limitation to the duration of the search has been set in the basic model. The
investor can search for the buyer as long as needed in order to optimize the
receipts from sale. This is unproblematic when the liquidation is planned and the
only incentive to sell quickly is the loss of income from an alternative
investment. Often, however, investors face some kind of a more or less explicit
deadline up to which the sale must be completed. The introduction of such a
deadline in the model results in certain complications; in particular, time
invariance is lost, and no universal search strategy valid in all periods exists
any more. The simplest way to allow for a liquidation deadline is to set a maximum
number of offers that can be viewed.243 A deadline means in this case that after
rejecting all allowed offers, the investor is forced to accept the last one, no
matter how good or bad it is. The solution to this problem is, in fact, more
straightforward and more general than in the case of the infinite horizon. The
complete strategy, including reservation prices and expected receipts, can be
derived using "backward induction".244 Optimal reservation prices are determined
for each stage of the search separately starting in the future, at the deadline,
and moving back to the beginning of the search. Since the value of the search is
equal to the expected net receipts from accepting the next offer and from
continuing to search, reservation prices in all periods can be obtained
recursively. Deter243

244

The finite horizon version of the search problem with a maximal number of offers
the so called Cayley-Mosel-problem is, in fact, the oldest one. See Cayley
(1896), p. 587; for a discussion see also Ferguson (2000), pp. 2.7-2.10. See
DeGroot (1970), pp. 277-278, Chow et al. (1971), pp. 49-50, or Ferguson (2000), p.
2.1.
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mining the optimal reservation price and the value of search for the basic model
with observations costs proceeds in this case as follows: there is no strategy if
the seller gets as far as to the deadline any offer has to be accepted then, so
the expected net receipts are simply: E(GN) = E(PN) c one period before the
deadline the seller has only the choice between the next and the final offer; she
should accept the next one only if it exceeds the expected net receipts from the
last offer; the value of search is then: E(G N-1) = E(PN-1| PN-1> pN-1*)(1-F(pN-
1*)) + E(GN)F(pN-1*) c in earlier periods, offers should be accepted if they
exceed the expected value of further search; expected receipts can be determined
recursively using search values of the later periods: E(Gn) = E(Pn| Pn> pn*)(1-
F(pn*)) + E(Gn+1)F(pn*) c Thus, the reservation price in this framework is not
constant. It comes closer to E(P) as the deadline draws nearer. This effect is less
distinctive when more offers are left until the deadline. Nevertheless, one cannot
assume that the same strategy can be applied in all periods and that the value of
search is constant. With an increasing number of periods the calculation effort
increases as well. The existence of a deadline becomes more problematic when
continuous time with random arrival times is considered.245 The deadline is then
defined by the maximum duration of the search in time units rather than by the
number of offers, which becomes random in this case. With the offer flow being a
Poisson process, as assumed in the real estate search model, there is always a
positive probability that any offer is or is not the last one. Thus, the search
strategy can be based only on the expectation about the number of offers remaining
until the deadline. The value of search at the moment t can be then defined as the
expected net receipts over scenarios with 0 to infinitely many remaining offers:
E(G t ) = E(G N = i) Pr( N = i t )
i =0
245

(2.39)

To my best knowledge, the case of search in a finite search horizon with continuous
time has not been analyzed in the literature yet.
2.3 The Real Estate Search Model

145

Note that providing an analytical solution to the above formula is very difficult,
if at all possible. In particular, the determination of the expected net receipts
conditioned on the number of remaining offers requires considering a separate
finite horizon search problem for each value of i. Since it is not possible to
review all different scenarios explicitly, it seems also impossible to determine
the expected result of further search and thus, the optimal search strategy
analytically. Hence, no clearly defined optimal search strategy seems to exist in
this case, and merely an estimation converging to the optimal solution may be
possible.

Both finite and infinite horizon models have their advantages and disadvantages.
The choice of the preferred model type is therefore not straightforward. It may
seem at first sight that investors indeed set deadlines when selling assets like
real estate. They may be enforced by legal regulations or result from investors'
internal rules. A deadline may also have an informal character be a kind of
investor's obligation to herself to have the matter dealt with up to some date.
Despite the fact that some kind of a deadline is often present when selling an
illiquid asset, its nature does not fully correspond with the limited horizon in a
search model. The latter one cannot be exceeded in any case the search process
ends no later than with the last offer. Deadlines faced by investors in reality
cannot be broken without incurring (substantial) costs. This means that an investor
could continue to search after the deadline if she accepts the consequences. These
could be legal fines, additional holding costs, or even bankruptcy if not-selling
would lead to the loss of solvency. These additional costs may be very high, but
they are not infinite, so that it might even be optimal to accept bankruptcy rather
than a very low sale price. In this sense, a deadline is a point at which the
opportunity cost of continuing the search increases rapidly. The correct way to
handle it would be therefore to split the search in two phases: a finite horizon
phase ending with the deadline and an infinite horizon phase applied after the
deadline. The usual opportunity costs (i.e., the profitability of an alternative
investment or financing costs) apply in the first phase; in the second phase,
however, deadline-breach costs (e.g., bankruptcy costs) are to be used. The value
of search after the deadline can be applied as the receipts from rejecting the last
offer in the finite horizon phase. The above considerations can be further
generalized by assuming that investor's time preference changes not only at the
moment of the deadline but is generally timevarying. This probably complies with
the attitude of sellers in many situations. As time
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Chapter 2: Search in Illiquid Markets

passes, the necessity of accomplishing the sale becomes more and more urgent. This
corresponds with an increasing discount rate in the model's nomenclature. In
consequence, the value of further search and the reservation price decrease; the
seller is more prone to accept lower offers.246 The discounting rate in this
setting is a function of time (duration of search), and the existence of a deadline
is its special case. Although the idea of time varying opportunity costs is very
appealing from the theoretical point of view, its practical implementation is
extremely difficult, if at all possible. With an infinite search horizon on the one
hand, and the lack of time invariance due to the varying discount rate on the other
hand, no definable search strategy is in sight.

2.3.3.2. Dynamic Market


It has been assumed so far that the distribution of offers is constant or changes
according to a predefined linear trend with random deviations. However, in some
markets non-linear changes are more typical taking most often the form of a cycle.
Cyclical patterns in prices, rents, and other variables are also observed on many
real estate markets.247 A linear trend may be still used to approximate their
development if the search period is short compared with the length of the cycle,
but the error will increase with an increasing duration of search. A cycle and
other regular patterns can be incorporated in the search model by introducing a
limited number of feasible offer distribution functions. Changes in the market are
reflected by switching between these functions. Thus a cycle means a recurrent
order of market regimes. Using an iterative notation analogue to (2.11) one may
describe the dynamic version of the model with a set of equations, one for each
state of the market. For a strictly cyclical economy, the market state denoted as
S1 is always followed by the state S2, which again is always followed by S3 etc.
The last state SN is followed by S1 starting a new round of the cycle. The market
states are described by the corresponding probability distribution functions of
offers: F1, F2, ..., FN. A search

246

247

The effect of a decreasing reservation price when the search takes longer than
expected may, however, also result from the revision of seller's idea about the
distribution of offers. The latter issue is discussed in the section 2.3.3.3. For
studies on real estate cycles see Pyhrr et al. (1999) and the literature cited
there.
2.3 The Real Estate Search Model

147

model with observation costs and a dynamic environment can then be defined by the
following set of equations:248
* * * E(G1 ) = E(P1 P1 > p1 ) 1 - F1 (p1 ) + E(G 2 ) F1 (p1 ) - c

E(G 2 ) = E(P2 P2 > p ) 1 - F2 (p ) + E(G 3 ) F2 (p* ) - c 2


* 2 * 2

(2.40)

...

E(G N ) = E(PN PN > p* ) 1 - FN (p* ) + E(G1 ) FN (p* ) - c N N N


Note that this approach is similar to the inverse deduction in the finite horizon
model the expected gain from search in one period is defined by the conditional
expected receipts form the next offer, provided it is accepted, and the expected
value of further search if the next offer is rejected. The difference is only in
the last term of the last equation instead of the expected value of the last
offer, when the search deadline is reached, the expected value of search from the
beginning of the cycle is used. By solving the equations with respect to pi*, the
optimal strategy can be determined. The optimal reservation prices in different
points of the cycle are not equal, but if the search continues for more than one
cycle, the order of subsequent reservation prices remains the same. For further
generalization, it can be assumed that the order of market states is not
deterministic and that random jumps are possible. This type of market dynamics can
be described in terms of a Markov chain with a specified transition matrix :249
11 12 22 21 = M M N1 N 2 L 1N L 2N O M L NN

(2.41)

The elements of the matrix are the probabilities of switches from one state to
another in the following period. E.g., 12 is the probability of a change from the
state S1 to S2; values on the diagonal of the matrix are the probabilities that the
market remains unchanged in the next period. The transition matrix can also be used
to assess the stabili248

249

Analogue formulas can be derived for other versions of the search model, including
the model with opportunity costs and the real estate model. See Karlin (1962), p.
154 ff., and Lippman/McCall (1976c) for Markov-type search models. For general
properties of Markov processes see, e.g., Meyn/Tweedie (1993).
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ty of the market the more probability mass is concentrated on the diagonal, the
more probable it is that the market will not change. Using the transition matrix,
the equation set (2.40) can be rewritten as follows:
E(G1 ) = E(Pi Pi > p* ) 1 - Fi (p* ) Ni + E(G j ) ij Fi (p* ) Ni - c i i
i
i =1 N i =1 j=1 N N

( ( (

) ) )

E(G 2 ) = E(Pi Pi > p* ) 1 - Fi (p* ) 1i + E(G j ) ij Fi (p* ) 1i - c i i i


i =1 i =1 j=1

(2.42)

... E(G N ) = E(Pi Pi > p* ) 1 - Fi (p* ) ( N-1)i + E(G j ) ij Fi (p* ) (


N-1)i - c i i i
i =1 i =1 j=1 N N N

Solving the set of equations with respect to pi* yields the optimal search strategy
as a vector of reservation prices. The value of search changes in the cyclical
frameworks and depends on the cycle phase. Thus, the expected net receipts from
liquidation at the beginning of the search depend on the state of the market at
this moment. This may be a serious practical problem, because liquidity analysis
often needs to be accomplished long before the search for a buyer begins the
starting state is, thus, unknown. One possible solution is the application of the
most probable state; another way is the estimation of the value of search as the
expected value over different possible initial market states. However, in either
case, the probabilities with which the search will begin in each of the states need
to be known. In the Markov approach, these probabilities can be obtained from the
steady state vector, which results from the transition matrix when the process is
running very long. Otherwise, an empirical estimation of the state probabilities or
a forecast of the market state (cycle phase) at the beginning of the liquidation
process is necessary. The application of dynamically changing markets in search
models surely adds more realism. However, it has a noticeable effect on the results
only when the average duration of the search process is comparable with the length
of the cycle. This is seldom the case in reality sales are usually accomplished
much too quickly for any economic cycle to take a noteworthy effect even on
extremely illiquid markets. Nevertheless, the
2.3 The Real Estate Search Model

149

Markov approach with multiple randomly changing regimes can be used to model search
in markets in which abrupt structural breaks are possible.

2.3.3.3. Unknown Offer Distribution and Learning


The assumption that the distribution of offers is known to the seller is surely one
of the most unrealistic ones. It is practically impossible to determine the precise
probabilities of offers since it would require the knowledge of individual
valuations of all market participants. In reality, sellers' knowledge ranges
between a good assessment and total uncertainty about the relevant distribution.
The most straightforward way to improve it is to use the offers received during the
search to revise the opinion about the distribution of offers. Thus, a learning
process takes place. A search problem with an entirely unknown offer distribution
is unsolvable in the general case.250 It is straightforward that no optimization is
possible if absolutely no information about the state of the market is available.
In reality, however, investors should be able to determine at least a set of
possible offer distributions as well as assign them (subjective) probabilities with
which they are expected. Learning means in this case accumulating information
indicating which of the possible distributions the seller is actually facing. The
search strategy remains unchanged in its core offers are accepted or rejected on
the basis of a reservation price. However, the way the reservation price is
determined changes substantially. It varies from one period to another as the
presumed offer distribution is updated with new information. Updating may refer to
its functional form as well as to any of the parameters. It seems, however, that
most frequently only the mean is corrected. In this case, an effect of a falling
reservation price is likely to occur. If the seller initially overestimated the
level of the average valuation of the property, she will probably gradually reduce
her assessment as lower offers arrive; but if she underestimated the value, the
property is likely to be sold before any correction of the reservation price is
possible.251

250 251

See Tesler (1973), p. 44. Note that a similar effect may also result when updating
refers to the dispersion of offers. Since, as discussed in section 2.3.2, the value
of search and the reservation price might increase with in the real estate search
model under certain realistic conditions, * would be set too high if was
overstated. This would lead to lowering the reservation price as the true value of
offer volatility is revealed in the course of search. In the opposite case, when
was underestimated, the sale would occur too quickly to allow substantial
corrections. However, since the effect of on the result of the search and on the
optimal strategy is partially ambiguous and depends on the values of other model
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Chapter 2: Search in Illiquid Markets

The seller's main problem in the situation of an unknown offer distribution is to


choose the optimal learning procedure. There are several alternative strategies
discussed in the literature. Tesler (1973) suggests dividing the process in the
"learning phase" and the "decision phase". The first n observations are used only
to estimate the distribution of offers and are always rejected. Starting with the
(n+1)st offer the search proceeds as in models with known distribution. The
determination of the optimal number of observations to pass, i.e., the optimal
length of the learning phase, is central in this approach. The goal is to increase
the efficiency of the search in terms of expected receipts compared to a "nave
search" without learning. An economically reasonable way to accomplish it is to set
n so that the (expected) additional search cost resulting from passing the first n
offers equals the expected additional gain resulting from the improved estimation
of the true offer distribution. The result is dependent on the set of possible
distributions and their probabilities, but also on the unit cost of offer
observation.252

In the above learning scheme, some observations remained unused in the sense that
they cannot be accepted. This may be uneconomical in some cases. It is generally
possible to receive a very high offer, which would be high under any possible
distribution, already during the learning phase. Rejecting it would mean losing a
unique opportunity. A more general learning rule is, thus, to use all offers both
for learning and for searching. The concept of Bayesian updating can be applied for
this purpose. According to it, the distribution having the highest posterior
probability after observing a new offer should be chosen from the set of possible
offer distributions. Posterior probabilities result from corrections of prior
probabilities assigned to different distributions according to the Bayes' decision
rule:253 Pr(Dist | Old New) = Pr(Dist | Old) Pr(New | Dist Old) / Pr(New | Old)
with: Dist - probability distribution from the set of possible distributions Old -
set of past offers New - new offer (2.43)

252

253

variables, decreasing reservation prices due to learning about the diversity of


valuations on the market are do not necessarily need to be observed. Tesler (1973)
demonstrates in his example (search for the lowest price) that learning only pays
when the unit search cost is not too high. For further reading on Bayesian analysis
see Press (1989), Bernardo/Smith (1997), or Congdon (2003).
2.3 The Real Estate Search Model

151

Several authors have analyzed the properties of searching strategies implementing


Bayesian learning.254 In the general case, this setting leads to severe problems.
Firstly, the reservation price property does not necessarily need to hold.255 This
is apparent in the following example: if only two probability distributions of
offers are possible, the first one assigning 100% probability to the value of 100
and the second assigning 1% probability to 200 and 99% probability to 300, than the
seller should accept an offer of 100 or 300 but reject an offer of 200.256 There is
no ex ante defined reservation price in this case. The second difficulty is that
the problem may not be time invariant (myopic), what means that no general search
strategy can be defined for the infinite case.

However, the above problems do not occur under certain restrictive conditions.257
One of such cases is when offers are normally distributed with a known variance but
unknown mean, which is updated. It can be shown that both the reservation price and
the myopic property (for appropriate parameters) still hold then, so that the
solution can be derived using standard procedures.258 This is probably the most
relevant case for real estate sale modeling. Normal distribution of offers has been
discussed in section 2.3.1.1, and it seems plausible to assume that its location
(mean) is the main parameter adjusted by searching sellers. Although the assumption
that the distribution of offers is not fully known doubtlessly complies with
reality, its application in the real estate search model is still problematic. The
first difficulty is associated with the intended application of the model.
Determination of the optimal selling strategy (reservation price) is only one of
the relevant aspects; much more important is the application in investment
decisions on illiquid assets. In the latter case, the goal is to assess the grade
of liquidity and to optimize the choice of investment alternatives with respect to
this feature. Considering liquidation strategies that remain undefined until the
sale procedure is actually conducted makes it difficult (if at all possible) to
assess the liquidity of an asset before it has even been purchased. Another reason
why learning has not been implemented in the real estate
254

255 256

257

258

See DeGroot (1968), DeGroot (1970), pp. 336-345, Kohn/Shavell (1974), Rothschild
(1974a), Rosenfield/Shapiro (1981), or Rosenfield et al. (1983). See Rothschild
(1974a), p. 701. See Rothschild (1974a), p. 701, Kohl/Shavell (1974), p. 102, or
Rosenfield/Shapiro (1981), pp. 4-5, for similar examples. Rosenfield et al. (1983)
review the conditions under which the properties that hold for the search with a
known distribution of offers also hold when the distribution is unknown. See
DeGroot (1970), pp. 345-353, Rosenfield/Shapiro (1981), and Rosenfield et al.
(1983).
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Chapter 2: Search in Illiquid Markets

model is its partial ambiguity in the relative approach. As mentioned above, it


seems realistic that not the whole form of the offer distribution but only its
parameters, in particular the mean, are unknown. Thus, learning from subsequent
observations is equivalent to sequentially correcting the mean. Variables in the
real estate search model are, however, defined in a relative manner and are
independent from the average level of offers. Adjustments of the mean during an
adaptive search would have no effect on the relative reservation price *. In this
sense, learning with respect to the level of market prices is already incorporated
in the real estate model.

2.3.3.4. Offer Recalls


No recalls are allowed in the real estate search model; yet, the possibility of
recalling past offers is given, at least to some extent, in most cases of selling
or buying illiquid assets. Allowing for this feature could therefore make the
analysis more realistic.259 However, it can be demonstrated that the possibility of
recalls does not affect the optimal search policy in simple models with stable
offer distributions and positive search costs like those presented in sections
2.2.3 and 2.2.4. Moreover, it never pays to recall any offer in these frameworks
even if it is possible.260 If an offer pi was not optimal in the period i, it is
also not optimal in the period i+1. In fact, waiting only induces additional search
and opportunity costs, so if an offer is acceptable, it should be accepted as soon
as possible. Otherwise, its value decreases with time due to discounting, and an
acceptable offer may become unacceptable. In other words, if pi<p* than the same
applies to (pi-c), which is the value of the offer one period later. However, the
above considerations apply only to "simple" models; in other cases, especially if
no myopic property can be established, recalls may become favorable. One case when
delaying the acceptance may pay is when the effective observation cost is negative,
i.e., when the income from holding the liquidated asset exceeds the cost of
observing new offers. If the net income per period is high enough to compensate for
the opportunity cost of waiting, it may be optimal to delay the decision in order
to earn one more payment and hope for a better offer in the next period. This
situation may occur in the real estate search model if is high compared to (-).

259

260

Search or sampling with recall is analyzed by Kohl/Shavell (1974),


Rosenfield/Shapiro (1981), Morgan (1983), or Rosenfield et al. (1983). See
Rosenfield/Shapiro (1981), pp. 2-3, or Ferguson (2000), p. 4.3.
2.3 The Real Estate Search Model

153

Another framework in which recalls can be optimal is a cyclical market, as


discussed in the section 2.3.3.2. The optimal reservation price is not constant in
this case. It is therefore possible that an offer, which was unacceptable in the
"old" market state, becomes acceptable in the "new" state; however, recalls make
only sense within one market cycle in this case. The recall problem is also
nontrivial when the searcher does not know the distribution of offers and is
learning during the search (see section 2.3.3.3). Each incoming offer influences
then her opinion about the buyers' valuations. These changes affect the optimal
reservation price, so that a formerly unacceptable offer can turn out to be
acceptable after the revision of the market assessment.

An even more realistic possibility of allowing for recalls in a search model is an


uncertain recall. In this case, the seller may recall past offers, but they are not
always available after being rejected for the first time. In other words, the
seller can fall back on a former bidder, but she cannot be sure if his offer is
still valid. A past offer that is still available at a later time can be treated as
a random variable with an appropriate (binominal) probability distribution.
Alternatively the duration of an offer can be viewed as a Poisson or a Weibull
process.261 Although widely discussed in the mathematical literature, search
problems with full recalls are not easily applied in practicable models. They
usually contain a maximizing function to choose the best of the past offers, which
is relatively difficult to model analytically. A simulation approach is handier in
this case.

2.3.3.5. Intensity of Search


In most search models, including the real estate one, the seller has no influence
on the behavior of potential buyers. In particular, she cannot influence their
interest in the property on sale. However, in many cases, it is realistic to assume
that the number of received offers is not exogenous to the liquidation process. The
seller is usually able to conduct marketing actions or actively search for buyers.
These measures intensify the flow of offers. The offer arrival intensity in the
continuous time model with Poisson offer flow can be used to incorporate the
possibility of influencing buyers' interest. It is achieved by expressing as a
function of seller's efforts. The more active she is in the search for a
261

See Karni/Schwartz (1977) and Landsberger/Peled (1977) for search models with
uncertain recall.
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Chapter 2: Search in Illiquid Markets

buyer, the more offers can be expected to arrive per unit of time. This brings
another strategic variable into the model the intensity of search. It has two
opposite effects: on the one hand, a more intensive search may allow accomplishing
the sale more quickly and reducing opportunity costs, but on the other hand, it
also generates additional costs (e.g., marketing expenses). Thus, also the search
cost c has to depend on the search intensity. The optimal "effort level" can be
determined by maximizing the value of search with respect to the intensity
variable.262

The intensity of offer arrivals can be also utilized to allow for the economic
state of the analyzed market. More interested potential buyers can be expected
during hot market periods resulting in a higher . The frequency of offers can also
depend on the characteristics of the sale object; e.g., a flat in a popular
location will probably raise more interest than one in the outskirts. However,
introducing these additional features may cause problems with the myopic property
of the model. With a time varying parameter no time invariance of the decision
situation can be ensured.

2.3.3.6. Listing Price


It has been assumed so far that only interested buyers make price offers. The
seller remains passive by only accepting or rejecting the incoming bids without
making any suggestions about the price that she would be willing to accept
immediately. This puts the seller in a better bargaining position because she does
not preclude any offer from being placed neither a very low, nor a very high one.
However, in many illiquid markets, e.g., residential real estate, it is common that
the seller quotes her preferred price, the so called listing price, which is the
starting point for further negotiations. The listing price is usually published
together with the sale offer and is the price that the seller would accept on the
spot. This does not, however, preclude bargaining a potential buyer with a
personal valuation of the property below the listing price may try to convince the
seller to lower the price. An important consequence of quoting a listing price is
that it constitutes the upper limit to the achievable selling price. No rational
buyer would offer more than the listing

262

The strategic choice of search intensity is treated by Benhabib/Bull (1983). Search


efforts have been discussed in the real estate literature mainly in the context of
seller's or broker's behavior and marker equilibrium; see Yinger (1981), Wu/Colwell
(1986), Yava (1992, 1996), or Anglin (1997).
2.3 The Real Estate Search Model

155

price even if his valuation was higher.263 For the model's mathematics, this means
cutting off the right tail of the offer distribution and allocating its whole
probability mass to one point the listing price. Another consequence is that the
listing price is treated by a potential buyer as a hint at the seller's reservation
price. He can use the gap between his valuation of the property and the listing
price to assess the chances of successful bargaining. If the chances are low, he
would probably not engage at all, i.e., not place any offer. This behavior results
in the dependence between the listing price and the frequency of offers (), which
influences the opportunity costs of the search (i.e., the discount rate ). The
level of the listing price may also influence the distribution of offers. Higher
offers are relatively more probable with higher listing prices since potential
buyers with lower valuations are then discouraged. The listing price becomes
therefore another strategic variable in the model and can be optimized.264

In the model with opportunity costs (Karlin's model) allowing for the listing price
results in the following expected net receipts from sale analogue to (2.18):
E (G ) = pL ( p L ) p dF(p p ) + p F(p p ) L L L L * 1 - (p L ) F(p * p L )
p - listing price - distribution of offers conditional on the listing price -
discounting factor as a function of the listing price

(2.44)

with: pL F(|pL) (pL)

If there was no impact of the listing price on the frequency or the distribution of
offers, an infinitely high listing price would maximize the expected receipts.265
However, as soon as such dependence exists, an infinite listing price would also
mean infinitely long intervals between offers sale would not occur because of the
lack of interested parties. The result would have been the same if the search had
not been undertaken at

263

264

265

Empirical studies show that sales above listing prices are very rare. Such cases
amounted to 3.8% of sold houses in the sample of Horowitz (1992, p. 118) and to
9.3% in the sample of Anglin et al. (2003, p. 100). In most cases this was probably
the effect of two or more potential buyers with high valuations bidding
simultaneously on the same property. The strategic role of the listing price in
real estate markets has been analyzed by Horowitz (1992), Yava/Yang (1995),
Miller/Sklarz (1997), and recently by Anglin et al. (2003). This can be easily
shown by assuming and F(.) in the formula (2.44) independent of pL and deriving
the equation with respect to pL. The result is positive for all values of pL
meaning that E(G) is an increasing function of pL.
156

Chapter 2: Search in Illiquid Markets

all. An infinite listing price would also be suboptimal if it influenced only the
offers' distribution and not the frequency, as shown by Horowitz (1992). The
implications of the listing price are not further followed in this book. It is,
however, clear that an optimal listing price exists. It has to be at least as high
as the seller's optimal reservation price, and it has to be finite; otherwise a
contradiction would arise or the search would become worthless. As soon as all
necessary functions are specified, it should be possible to find at least
approximate values of both the listing and the reservation price maximizing the
value of search.

2.3.3.7. Search for the Best Seller


The final question relevant for the liquidity problem is the search for the best
seller. As already noted in section 1.4.2.3 in Chapter 1, investors are not only
facing liquidity problems when selling an illiquid asset, but also when buying one.
Finding an investment with required characteristics may be a time-consuming
undertaking, leaving the investor with the typical liquidity dilemma between buying
quickly and buying at a reasonable price. The search problem resulting in this case
is analogue in its nature to the search for the best buyer.266 Several adjustments
to the original model are, however, necessary. Taking the buyer's point of view
requires redefining the "offer distribution". Since the buyer is now reviewing
potential sellers, each offer refers to a different object. However, an offer
distribution can be defined only with respect to identical or at least similar
alternatives; otherwise, comparability of prices cannot to be fully maintained.
This is difficult for many heterogenic assets, including real estate, where each
property is more or less unique. Hedonic methods using econometric modeling to
attribute prices paid for real estate to the characteristics of the sold properties
(number of bedrooms, location quality, construction year etc.) may be of help at
this point.267 On this basis, a hypothetical price distribution for a concrete
investment can be simulated. An alterna-

266

267

See Anglin (1997) and Chun (2000), pp. 327-329. The search for the best buyer is
discussed in the real estate literature mainly in the context of market models.
Sellers and buyers search simultaneously generating market equilibrium in Wheaton
(1990), Yava (1992), Williams (1995), Krainer (1999), or Krainer/LeRoy (1997,
2002). Hedonic methods are often used for the construction of real estate indexes.
See Ferri (1977), Wallace (1996), or Thomas (1997, p. 162).
2.3 The Real Estate Search Model

157

tive approach could be based on some kind of an atypicality measure, like the one
developed by Haurin (1988). The issue of inspection or appraisal costs is related
to the above problem. Information asymmetry between buyers and sellers is immanent
to heterogenic assets. In most cases, the seller is substantially better informed
about the true characteristics of the traded asset than the (potential) buyer. This
makes it difficult for the latter one to properly assess the quality of the
received offer. The typical way to cope with this problem is an independent
inspection or an appraisal of the transaction object. The resulting costs are
accrued whenever a new offer is considered increasing the overall search costs.
Summing up the above considerations, the expected expense (E) resulting from the
search for an illiquid asset in the basic search framework with observation costs
can be computed as follows:

E(E) = E(P P < p ) + B


with: B*

c+ 1 - F(p ) B

(2.45)

- reservation price in the purchase case - appraisal cost

For the relative version of the search model and normally distributed offers, the
following formula results:268

E ( ) =

* -1 * -1 - - X + +- * -1 X X - + X

(2.46)

The final adjustment concerns the substitution of the maximization of the value of
search with its minimization. Obviously, a buyer is interested in the lowest
possible expense; thus, the way of reasoning in the whole model changes
respectively. The reservation price in this case is the maximal price, which the
buyer should accept. This adjustment is relatively simple and encompasses only a
slight change in the optimization algorithms.

268

See Appendix A.2 for the derivation.


158 2.3.4. MCS Solution

Chapter 2: Search in Illiquid Markets

The considerations on the search problem presented so far were based on analytical
models, which can be specified in a more or less general form by using analytical
formulas. This approach has serious limitations considering its solvability in
specific cases. The search framework behind the model, like the basic sale
situation presented in section 2.2.1 or the real estate liquidation framework
presented in section 2.3.1, contain numerous simplifications and assumptions. Many
of them can be overcome (see section 2.3.3) or result in only negligible
misspecifications. Nevertheless, in some points, the realism of the model may be
insufficient to allow acceptable approximation of real markets. A simulation
approach, often referred to as the Monte Carlo Simulation (MSC), is an interesting
alternative in such cases.269 Its great advantage is the possibility of easy
implementation of practically any thinkable additional condition; the only limit is
the computation power. Monte Carlo methods have been used in optimal stopping
problems mainly for the valuation of American options, where an optimal realization
of an option is crucial for its value.270 Other applications in the search theory
are rather rare, which is probably due to the predominantly theoretical analysis in
this field. Nevertheless, despite several problems, the use of MCS in the search
for the best buyer may allow an insight in the effects of certain additional
conditions, which otherwise would be difficult to analyze. The sense of a
simulation approach lies in repeating a predefined scenario under varying
environmental variables and observing the results. In the case of the search for a
buyer, it means rerunning the search and sale process. Each replication represents
some hypothetical scenario and leads to a hypothetical realized selling price. By
generating a large number of such replications, it is possible to assess the
distribution of the net sale receipts. Of course, a simulation can never perfectly
reflect the reality, but the fit increases rapidly with an increasing number of
replications. With today's data processing technology, a sufficient level of
accuracy for most practical applications can be achieved even with a personal
computer. Each simulation uses two types of variables: the certain ones, remaining
constant in all runs, and the uncertain ones, varying from one run to another and
depending on the
269

270

An excellent review of Monte Carlo methods offers Gentle (1998). See also
Robert/Casella (1999), Jckel (2003), or Glasserman (2004). For a comparative study
of MCS algorithms for pricing American options see Fu et al. (2001).
2.3 The Real Estate Search Model

159

assumed nature of their uncertainty. The former ones represent either facts, like
fixed notary fees or tax rates, or assumptions, like the personal discount rate.
Since they remain constant, they constitute the general simulation framework. In
contrast, the varying variables are the ones that are to be studied. By assigning
them different values, their influence on the target is analyzed. In particular,
price offers fall under this category in search models. The decision which
variables in the process should be simulated and which should remain constant
depends on the goal of the analysis. The more uncertainty is allowed, the more
precise are usually the results. There is, however, a tradeoff between the range of
simulated variables and the computation effort necessary to preserve the desired
accuracy. The number of runs necessary to retain a constant level of precision
increases exponentially with every additional simulated variable. Characteristic
for Monte Carlo approaches are computer generated random variables. This issue is
simultaneously a serious technical problem and a great advantage of these methods.
Depending on the knowledge about the probability distributions of the simulated
variables, two different approaches can be followed. If the stochastic process
behind the variable is known, and its distribution function can be assumed with
sufficient certainty, random number generators can be applied to obtain series of
values with required characteristics. Such generators exist for most of the popular
distributions.271 When no distributional assumption is possible, the only source of
information is an observation sample. The first straightforward approach is to use
the sample data directly in the simulation by scrambling the association of the
data points, i.e. combining different values of the variables.272 This approach has
two major drawbacks: firstly, only a limit number of scenarios can be generated
this way, and secondly, some of the available observations may be older and not
necessarily comply with the current situation. Two alternative techniques available
in this case are jackknife and bootstrap.273 The first one is used mainly to obtain
better estimations of distributional parameters of variables. Single (or multiple)
observations are removed from the sample, and parame271

272

273

A simple method of generating variables from any continuous probability


distribution includes the generation of a uniformly distributed series and the
application of the distribution's inverse c.d.f.. Numerous other approaches are
discussed in the literature. See Gentle (1998), pp. 1-38 and 85-118, or Glasserman
(2004), pp. 39-77. This approach corresponds with the randomization techniques in
randomness tests (see Edgington, 1995) or with the historical simulation used for
computing Value at Risk (see Jorion, 2001, pp. 221 ff). For more extensive
presentations of the jackknife and bootstrap techniques see Shao/Tu (1995) or
Efron/Tibshirani (1998).
160

Chapter 2: Search in Illiquid Markets

ters are recalculated on the basis of a reduced sample. Using these results a
jackknife estimator is computed having a reduced bias compared to the original
parameter. The central idea of the bootstrap is to treat the sample as if it
represented the whole population.274 Observations are drawn randomly from the
original sample with replacements building bootstrap samples. The number of "new"
samples that can be generated this way depends on the size of the original sample.
An especially interesting application of the bootstrap is the possibility of using
the averages from bootstrap samples as additional (artificial) observations. Adding
them to the original ones increases the "density" of the sample allowing better
assessment of the variable's probability distribution. An advantage of both
jackknife and bootstrap is their easy implementation, which can be accomplished
even in a common calculation sheet.275 A possible MSC algorithm of the real estate
liquidation problem analyzed in this chapter is presented in Figure 2-3. The
simulation process itself is contained within the shaded area, and the assumptions
are depicted on the left side of the Figure. The solid arrow lines indicate the
direction of the algorithm, and the dotted ones mean that a variable or a partial
result is to be applied. Before the simulation can start, its parameters need to be
set. They include the reservation price and other deterministic variables (discount
rate, trend, rental revenues) as well as the distributions of the random variables.
The latter can be based on assumptions or derived from observation samples. The
process begins with the generation of a random offer from the distribution of
buyers' valuations. The offer is compared with the reservation price and dependent
on the result either a new offer is generated, or the sale is concluded. In the
former case, the number of offers (periods) is increased by one. In the latter
case, a market change and time intervals for all periods are generated from the
respective distributions. They are used to calculate capitalized rental revenues
and the discounted sale price. The value of the total net receipts from sale
results as the sum of the price and the income component. After updating the
receipts' distribution, a new replication starts from the beginning.

274 275

The bootstrap was proposed as an extension of the jackknife by Efron (1979). See
Woodroof (2000) for the application of bootstrap in the Lotus 1-2-3 environment.
2.3 The Real Estate Search Model

161

Simulation parameters
Start

Simulation process

Basic offer distribution

Generate an offer Update the number of offers i

Reservation price (*)

Is > *?

No

Yes Distribution of market changes Generate a market change a

Distribution of time intervals

Generate time intervals t1...ti

Interest rate () Market trend ()

Calculate discounting factors

Rental revenues ()

Calculate discounted rental rev.

Calculate discounted sale price

Calculate net receipts

Process flow Variable application

Update the distribution of receipts

Figure 2-3: Scheme of a Monte Carlo Simulation for the real estate sale process
162

Chapter 2: Search in Illiquid Markets

The final result of the simulation is an estimation of the distribution of net


receipts for a given set of parameters. An example of such distribution obtained
with a MCS is presented in Figure 2-4. Its accuracy depends strongly on the number
of replications, but it should be sufficient after a few thousand runs in most
cases. Various statistics, including probabilities of certain outcomes, moments of
the distribution, as well as complex ratios and other measures can be computed on
the basis of this distribution. Another important advantage of the MCS is the
possibility of easy implementation of further features. New conditions and
additional environmental variables can be added, or the character (e.g.,
randomness) of the existing parameters can be changed by simply adding new nodes in
the simulation algorithm. Also constraints, which are present in the search model
in order to ensure its solvability, do not apply here. Especially, no restrictive
assumptions about the probability distribution of offers or other random variables
are necessary. Due to the possibility of using empirical distributions, this
problem is practically nonexistent.

9,0% 8,0% 7,0% 6,0% 5,0% 4,0% 3,0% 2,0% 1,0% 0,0% 0,36 0,49 0,62 0,75 0,88 1,01
1,14 1,27 1,40 1,53 1,66

Frequency

Net Sale Receipts

Figure 2-4: Monte Carlo estimation of the distribution of net receipts from sale276

276

Monte Carlo Simulation with 10.000 runs and following parameters: reservation price
= 1.2, offer volatility = 15%; rent = 5%; trend factor = 5%; discount rate = 15%;
offer frequency = 52 p.a.; normally distributed market changes (A) with the
volatility of 5%.
2.3 The Real Estate Search Model

163

Despite the numerous advantages, a possibly serious problem with the simulation
approach is the determination of the optimal reservation price. The distribution of
net receipts determined in the simulation is only valid for one concrete value of
*. In order to "try out" other reservation prices, one needs to rerun the whole
simulation. This may lead to an enormous computational effort: with an increasing
number of different values of *, the number of replications increases
geometrically. Since it is not possible to analyze receipts' distributions for all
*, the only reasonable alternative is to concentrate on ranges in which the optimal
reservation price is suspected. This approach will probably yield good results in
most cases, especially, if the existence of a unique optimal * can be proved
analytically. However, when a modified search model is considered, or when the
optimality criterion is other than maximizing expected receipts, this problem
becomes a serious hindrance.277 It is even more severe when a varying reservation
price is assumed. 2.3.5. Liquidity within the Model

In order to complete the presentation of the real estate search model on which most
of the analysis in this book is based, it is necessary to state explicitly how
different aspects of liquidity are captured within it. The two dimensions of asset
liquidity and the sources of liquidity identified in Chapter 1 constitute the
reference points for the discussion. To begin with, recall the liquidity definition
of Keynes: an asset is more liquid if it is "more certainly realizable at short
notice without loss".278, 279 The two main aspects of liquidity can be derived from
it: the duration of the liquidation process and the price realized at liquidation.
The presence of the latter aspect in the search model is obvious the (relative)
net liquidation receipts can be regarded as equivalent to the liquidation price.
Interpreted in the sense of Keynes, E() should be not lower than 1 or a "loss",
i.e., a discount to the fair value, would result. The reference to the liquidation
time can be considered in terms of the expected duration of search (D) in the
model, search can end only with a sale, so that the two notions are, in fact,
identical. Further277

278 279

Especially, when a risk-minimizing reservation price is of interest, the


identification of its optimal value using MCS may prove to be difficult. See
section 3.3, especially 0. Keynes (1930), p. 67. See also Lippman/McCall (1986) for
the discussion on the consistency of the search theoretical approach to liquidity
with the Keynesian liquidity definition.
164

Chapter 2: Search in Illiquid Markets

more, the formal definition of the expected value of D formulated in (2.23) implies
also the identity of the expected duration of search and the reservation price.
Since E(D) is a function of the reservation price p*, each reservation price always
corresponds with a specific expected duration of search; and since the probability
function F(.) is by definition continuous and monotonous, each value of the
expected duration of search corresponds with a specific reservation price (or
prices). A non-ambiguous relation between the duration of the sale process and the
expected net receipts from sale is the consequence of this identity. Since the
reservation price determines both the expected receipts and the search duration, it
can be represented by a locus of E() and E(D). For the real estate search model,
the locus takes a form similar to the one presented in Figure 2-5. Note that it
highly resembles the relation between the present value of the selling price and
the selling time depicted in Figure 1-7 and Figure 1-8.

1,4

1,2

Expected Net Receipts

0,8

0,6

0,4

0,2

0 1 100 10000 1000000 100000000 1E+10 1E+12

Time on the Market

Figure 2-5: Locus of expected net sale receipts and search duration in the real
estate search model

Having recognized the main features of the liquidity (marketability) definition in


the search model, it is purposeful to check whether it also adequately captures the
sources of liquidity. If it wasn't so, the model would provide only an incomplete
picture of the problem. The presence of transaction costs (direct and opportunity
costs) is relatively
2.3 The Real Estate Search Model

165

straightforward.280 On the one hand, direct costs are allowed for in the levels of
offers. Since the prices offered by potential buyers are assumed to be net of all
costs, commissions and taxes are deducted already at this point. On the other hand,
the costs that are born during the search and the evaluation of offers are regarded
as observation costs and netted with rental revenues (see section 2.3.1.4).
Opportunity costs are captured in the model through a number of factors. Since the
discount rate expresses the decision maker's time preference, it also reflects the
returns from an alternative investment that could have been earned if the property
was sold more quickly. Market timing costs, i.e. the costs resulting from a
negative change of the market situation during the liquidation, are expressed by
the (expected) market trend and the (unexpected) market uncertainty factor. The
expected change of the level of arriving offers during the search is equal to the
market trend parameter. On the other hand, the risk of an unexpected development is
considered by the inclusion of the market uncertainty parameter A. Another source
of liquidity identified in Chapter 1 is the diversity of valuations of the asset in
question by market participants. Also this aspect is very apparent in the search
framework. Since the level of the arriving purchase offers is random, one can treat
them as the effect of random drawing from the distribution of property's valuations
among investors. Hence, the mere fact that different offers are placed by different
sellers during the search reflects the valuation diversity. The allowance for
market organization is less clearly visible in the model. In fact, the core idea of
the sequential search is identical with that of a direct market on which sellers
and buyers search, find each other, and negotiate transaction prices individually.
Hence, the search theoretical approach proposed here seems to be most appropriate
for this type of markets. However, brokered markets can also be easily described in
the search framework. Also here, the seller reviews a number of sequentially
arriving offers and decides to accept one that complies with her requirements. The
main difference to a direct market lies in the values of model parameters. Since a
broker is usually in a position to establish contact to a larger number of
potential buyers, the frequency of offers should be higher. A broker should also be
able to filter out unserious traders,
280

Indirect transaction costs have been recognized in section 1.2.2.2 in Chapter 1 as


a phenomenon caused by illiquidity, or even equivalent with it, and not as a source
of liquidity. Therefore, this type of transaction costs should be explained by the
model rather than enter it as an explanatory variable. In fact, the real estate
search model can explain the existence of certain indirect transaction costs, as
demonstrated, e.g., by the implicit bid-ask spread in section 3.1.2.1 in Chapter 3.
166

Chapter 2: Search in Illiquid Markets

so that their offers would not be reviewed at all. In effect, the seller would be
facing a slightly different distribution of offers compared to the direct market.
Interpretation of the search model in the context of a dealer market is more
difficult. The search is then conducted not among potential individual buyers or
sellers but among different dealers. Application of the model would require several
more fundamental adjustments. Firstly, due to the relatively small number of
dealers active on the market, it might be more appropriate to assume a finite
search horizon (see section 2.3.3.1). Secondly, the impact of market fluctuations
on the realized liquidation values would be relatively high, so that the issue of
appropriate modeling of this aspect should be given special attention (see
discussion in section 2.3.1.5). Nevertheless, in view of the presumably very low
dispersion of offers, the usefulness of the search model in this case is rather
doubtful. The application of the model to assets traded on auction markets is even
less purposeful. Since no search takes place there, and traders are matched
automatically, there is little point in analyzing search processes. However, if one
interprets the flow of orders arriving on the exchange as a flow of offers and
regards the short-term (intraday) variations of these offers as the result of
investors' heterogeneous valuations, the trading activity on an auction market can
indeed be interpreted as an intense search process. Limit orders have the function
of reservation prices and market orders are equivalent to selling to the first
incoming bidder. Nevertheless, also in this case, there seems to be little
practical use from the application of the search theoretical approach. Hence, the
main intended fields of application of the search model are non-organized markets
with less trading activity and lower levels of liquidity.

2.4.

Search and the Functioning of Illiquid Markets

The analysis in the former sections concentrated on the optimal behavior of an


investor selling an illiquid investment, in particular real estate. The main issue
was the possibility of influencing the outcome of her actions by optimizing the
search strategy, which in this case took the form of a reservation price. It
followed that a rational investor should not treat the search for a buyer as fully
exogenous but act strategically. The search problem has been approached from the
perspective of an individual investor. This was in line with the goal of the
analysis formulated in the Introduction, that is, the provision of a practical tool
to include liquidity as a decision criterion. However, the
2.4 Search and the Functioning of Illiquid Markets

167

results of the search theoretical analysis have implications not only for
individual investment decisions but also for the functioning of illiquid markets.
The main point of interest when considering the effects of search in illiquid
markets is the analysis of the situation of market participants compared with their
situation in liquid markets. The starting point of such considerations is the
relationship between the maximum expected receipts from sale and the hypothetical
price that could be realized in a liquid market. Due to the lack of organized
trading systems, determination of hypothetical market prices is a major problem for
most illiquid assets. It seems plausible to assume that the average valuation of
the asset by market participants would constitute the single market price if
perfect liquidity was given. Thus, the mean of the distribution of buyers' opinions
about the value of the asset can be treated as a "quasimarket price". On the other
hand, expected net receipts from sale correspond with the effective price
achievable on average by a seller following the assumed liquidation strategy. If
she set her reservation price at minus infinity (i.e., she accepted the first offer
to come), she could expect to receive the asset's average valuation adjusted by
one-time cost (or income) arising from the necessity to wait for the first
offer.281 Thus, when search costs are negligible, setting an infinitely low
reservation price results in expected receipts equal to the quasi-market price.
However, by optimizing the search strategy, higher expected net receipts are
usually achievable. In fact, simulations with plausible parameters for the real
estate search model have shown that "beating the average" is a rule rather than an
exception. This effect diminishes with increasing costs of search or decreasing
heterogeneity of buyers, and it disappears if the former is too high or the latter
is too low. Nevertheless, the maximum expected receipts from sale should still lie
above the quasi-market prices in many markets. The straightforward conclusion from
the above considerations is that, in certain circumstances, illiquidity can allow
the seller to achieve higher gains than it would be possible when the asset was
perfectly liquid. In organized markets, like stock exchanges, only one price
exists, and it is equal for all investors. There is no direct possibility to take
advantage of the fact that some buyers would also be ready to buy at higher prices.
This "consumer surplus" can, however, be utilized if no organized market exists,
and potential buyers have heterogeneous opinions about the asset's value. It
281

The fact that an infinite negative reservation price is economically unreasonable


and that the seller's personal valuation is the actual lower limit is ignored at
this point.
168

Chapter 2: Search in Illiquid Markets

turns out that illiquidity does not necessarily need to be disadvantageous. In some
cases, it may even be more favorable for certain market participants to act in an
illiquid market with no organized trading systems and no transparency regulations.
However, this conclusion must be interpreted with caution. Even if the model
indicates that the maximum receipts from sale are above the average level of
offers, it does not necessarily mean that they are above the hypothetical liquid
market price. Firstly, it must be noted that "beating the market" in the above
sense has a solely subjective character. It has been already argued in the previous
sections that, in the ideal case, the distribution of offers applied in the search
model should arise from the valuations of the asset among all potential buyers.
Yet, determination of the true distribution is a practical impossibility. Only an
omniscient investor could know it, and hence only a prophet could truly "beat the
market". The ordinary seller can only fall back on her assessment of the
distribution, which is always subject to individual information. It may be possible
for her to outperform the market from her point of view, but there is no guarantee
that her view complies with objective reality. There is always some risk that the
assessment of the offer distribution was wrong, and what subjectively seemed to be
a good value was, in fact, far below the average achievable price. The matter
becomes even more complex when not only sellers but also buyers are allowed to
search for the best price.282 Buyer's search for the best seller when there are a
number of comparable houses on the market was discussed briefly in section 2.3.3.7;
apart from several slight adjustments in the formulas, the same principles as in
the sale case apply. This means that also a buyer can (subjectively) "beat the
market" by optimizing the search strategy. If search costs are not too high and
potential sellers are heterogeneous enough, she can expect to obtain the desired
asset at an effective expense below the average valuation on the market. Thus, same
as for sellers, illiquidity can be advantageous for buyers. This, however, leads to
a logical problem: how can buyers expect to buy below the average market price and
simultaneously sellers expect to sell above the average? This contradiction can be
explained within the model by the already mentioned subjectivity of the parameters
used for determining the optimal policy. Market participants do not all face the
same distribution of offers. Since sellers
282

Search models with both sides of the market analyzed simultaneously are considered
by Wheaton (1990), Quan/Quigley (1991), Yava (1992), Krainer (1999), Krainer/LeRoy
(2002), or Fisher et al. (2003); however, they do not quite correspond with the
two-side strategic search problem mentioned here.
2.4 Search and the Functioning of Illiquid Markets

169

search for bids above their reservation prices and buyers search for offers below
their reservation prices, the distribution of buyers' bids should tend to lie
further to the left than the sellers' offer distribution. It is than by all means
possible that at least some of the buyers' reservation prices lie above the
sellers' reservation prices making transactions possible in which both parties
subjectively outperform the market (see Figure 26).283 The final distribution of
offers on both sides is, however, the result of a complex market game and may be
unstable.

Frequency

Investors' valuations of the asset Buyers' reservation prices Sellers' reservation


prices

Direction of the search

Price building room

Reservation Price / Valuation

Figure 2-6: Reservation prices of buyers and sellers and the price building in
illiquid markets284

The above considerations only touch the issue of price building in illiquid
markets. Strategic search by all participants generates a market wide game, which
is too complex to be fully analyzed in this book. Yet, even these introductory
notes allow the conclusion that illiquidity may be advantageous to some investors.
This applies especially to those, who are able to assess the distribution of offers
on the opposite side of
283

284

Note that these considerations refer to the reservation prices, which are always at
least as high (low) as sellers' (buyers') valuations of the asset. The fact that a
price building room between the reservation prices exists ensures the possibility
of a trade profitable for both sides of the market also in terms of individual
valuations. See Geltner (1997) and Fisher et al. (2003).
170

Chapter 2: Search in Illiquid Markets

the market more precisely. They should be able to take advantage of their superior
knowledge at the cost of the "nave" market participants. *** Models presented in
this section, though doubtlessly extremely interesting as a source of knowledge
about strategic behavior of investors in direct markets, were intended mainly to
provide the methodical framework for further considerations. Since search turns out
to be crucial for the phenomena discussed in this book, search models seem to be
perfectly suited to cope with the problems arising from the lack of perfect
liquidity. As shown in the course of the analysis in this Chapter, they allow
examining the effects of the main sources of liquidity, such as the heterogeneity
of market participants, the lack of market organization, or the existence of search
costs. Furthermore, asset and investor specific characteristics, such as modalities
of the search process, time horizon, or market dynamics, can also be taken into
account. Application of the search theory in liquidity measurement and management
techniques developed in the subsequent chapters confirm the enormous flexibility of
this approach. It turns out that nearly any liquidity related problem can be
presented in terms of a search model. In this context, further research on methods
dedicated not only to real estate but also to other illiquid assets gains
particular importance.
Chapter 3 Liquidity Measurement

The definition of liquidity provided in Chapter 1 is crucial for the delimitation


of this feature from other relevant characteristics of investment alternatives.
However, it is still insufficient for the application in formal decision models a
more precise notion is needed for this purpose that would allow an unambiguous
comparison of investment alternatives with respect to their grades of liquidity.
Having to choose between two otherwise identical assets, a rational investor will
prefer the more liquid one, but she has to be able to identify it. A quantitative
measure of liquidity is, thus, inevitable if it is to be considered as a decision
criterion. However, due to its multifaceted character, it is very difficult, if at
all possible, to define a single ratio that would adequately encompass all aspects
of this phenomenon. This part of the book summarizes and discusses different
possible approaches. While the main goal of the Chapter is the presentation of
various liquidity measures, it is done against the background of search theoretical
considerations. As argued earlier, the necessity of a more or less intensive search
for a trading partner when selling or buying certain assets is the main source of
their illiquidity. It should be therefore possible to interpret various liquidity
measures in terms of a search problem. Indeed, it turns out that a link to search
processes in illiquid markets can be established for many of the existing
measurement approaches, even for those which seem to have nothing in common with
search at first glance. Since liquidity of real estate markets is the main focus of
the analysis, the real estate model is applied throughout the Chapter, so that the
search-based versions of the discussed liquidity measures refer mainly to the case
of direct property investments. However, like in other parts of the book, the
restriction to real estate should be treated in terms of an example analogical
considerations could also be applied to other illiquid assets. The Chapter begins
with the presentation of traditional liquidity measures referring to the liquidity
of organized public markets. This subject has been researched for several decades
already, mainly in the context of market microstructure. A number of different
methods have been developed of which the bid-ask spread is undoubtedly the most
popular one. Although these measures have originally been developed for publicly
172

Chapter 3: Liquidity Measurement

traded assets, they can also be used with private investments to some extent. This
is demonstrated in the discussion of the possibilities of their application to
direct real estate. The next group of measures refers to the probability of
successful liquidation; hence, they are labeled as "probability-based" approaches.
Unlike the traditional ones, they measure liquidity on the asset rather than the
market level and have been applied mainly to assets traded in direct markets. Both
traditional and probability-based approaches refer predominantly to marketability
they focus on the expected outcome of liquidation either with respect to the price
dimension or with respect to the time required to accomplish it. They fail,
however, to account for uncertainty about the liquidation value, which is immanent
to illiquid assets. A separate section is therefore devoted to measures of
liquidity risk. Only few specific approaches have been developed in the literature
for this purpose. The section consists therefore mainly of own propositions made on
the basis of general risk measurement principles and the real estate search model.
Finally, a family of measures combining various aspects of asset liquidity in one
figure is presented. Several approaches classify to this section. Among them are,
on the one hand, liquidity performance measures, designed in analogy to return
performance measures, and, on the other hand, utility-based measures based the
concept of investor's personal utility. Especially the latter group constitutes a
bridge to the concept of liquidity management presented in Chapter 4.

3.1.

Traditional Measures of Market Liquidity

The problem of liquidity measurement was traditionally discussed in reference to


public markets, especially stock exchanges, and the development of specific methods
was mainly for the purpose of studying the effects of liquidity on stock prices,
market returns, and related issues. Most of the existing approaches are therefore
empirical proxies for unobservable liquidity rather than autonomous measures. They
can be classified according to the three dimensions of market liquidity discussed
in section 1.1.1.2 as measures of breadth, depth, and resiliency, referring to
immediacy costs, large-trade effects, and the speed of market reactions,
respectively. After reviewing the most popular approaches in their original forms,
possibilities of their application to direct real estate investments are
considered. The analysis on the basis of the search model from section 2.3 yields
several possible measures, which allow capturing liquidity of nonpublicly traded
assets in a similar manner as it is done for more liquid public markets.
3.1 Traditional Measures of Market Liquidity 3.1.1. Liquidity of Public Markets

173

3.1.1.1. Bid-Ask Spread


As already discussed in section 1.1.1.2, market breadth is generally understood as
the "distance" between the sellers' and the buyers' side of the market. On markets
on which dealer services are offered, its natural measure is the difference between
the bid (price for immediate buying) and the ask (price for immediate selling).
Demsetz (1968) was probably one of the first to interpret the bid-ask spread in
terms of a liquidity measure.285 From the investor's point of view, it constitutes
the cost of an immediate execution and, thus, the cost of turning an illiquid asset
into a liquid one. In order to buy quickly, one has to pay a premium on the
presumed fair price, and in order to sell quickly, one has to pay a commission
reducing the effective sale value. Analyzing the spread from the dealers' or market
makers' point of view allows a deeper insight into its connection with liquidity.
For an individual (or institution) who commits oneself to trade at any time with
any investor who accepts the quoted prices, the difference between the bid and the
ask constitutes the profit margin. In a competitive market, it should be set just
to cover the costs caused by providing liquidity. The determinants of these costs
have been analyzed by many researchers; the general agreement is that they consist
of three main components:286 order processing costs, including the costs of being
a market maker (e.g., the price of a seat on the exchange), inventory costs,
i.e., the costs of holding a sufficient inventory to bridge the time gap between
buy and sell orders,287

285

286

287

Strictly speaking, Demsetz made the connection between the bid-ask spread and
transaction costs; the reference to liquidity is indirect, expressed in the
definition of the spread as the cost of making transactions without delay. See
Demsetz (1968), p. 39. See Tinic (1972), Stoll (1978), p. 1133, Glosten/Harris
(1988), Stoll (1989), p. 115, Glosten (1987), p. 1293, or Iversen (1994), pp. 28-
51. For an early analysis of the spread components see also Demsetz (1968), pp. 40-
45. For inventory models explaining the bid-ask spread see Garman (1976), Stoll
(1978), Amihud/Mendelson (1980), or Ho/Stoll (1981).
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Chapter 3: Liquidity Measurement

adverse selection or information costs, i.e., the costs of exposition to the


activity of informed traders who may take advantage of their superior knowledge at
the cost of the market maker.288 While the first component is directly observable
und widely unproblematic, both latter ones require a closer consideration. Lower
liquidity of a public market means, in particular, less frequent trades. Thus, the
market maker needs more time to match both sides of the market, and the size of the
inventory must increase if the market making function is to be conducted without
interruptions. This forces the market maker to hold a portfolio deviating from the
optimal one and justifies a higher premium for his activity.289 The problem of
informed traders additionally amplifies this effect. With less trade a single
transaction gains more weight, and the impact of informed trading is stronger. The
reward for the risk of losses incurred in such transactions widens the spread. The
absolute distance between the bid (PB) and the ask (PA), i.e., the quoted spread,
though doubtlessly closely correlated with liquidity, is still an imperfect
measure. Its main weakness is the lack of direct comparability between different
assets (stocks). In order to correctly assess assets' relative liquidity, price
levels need to be accounted for. Hence, the relative spread is more informative at
this point. Another problematic issue is the fact that market participants are
often able to trade within the official spread. The bids and asks quoted by market
makers denote only the upper and the lower bound for individual transaction prices
(Pt).290 Thus, more precise liquidity measurement can be achieved with realized
effective spreads. Considering the above drawbacks several alternatives have been
proposed in the literature:291

288

289

290

291

On the role of asymmetric information in the determination of bid-ask spread see


Copeland/Galai (1983), Glosten/Milgrom (1985), or Kyle (1985). See Stoll (1978) for
the analysis of dealer's inventory holding costs in terms of deviations from the
optimal portfolio composition. See Roll (1984), p. 1127, Grossman/Miller (1988), p.
629, Stoll (1989), pp. 115-116, or Huang/Stoll (1996), pp. 326-333. Bertin et al.
(2005) find that ca. 17%-18% of REIT (Real Estate Investment Trust) transactions
and ca. 22%-23% of non-REIT transaction transactions on the New York Stock Exchange
are made within the quoted spreads. Empirical data on the relation between the
quoted and the effective spread is also presented in Chordia et al. (2001a), pp.
508-509. See Chordia et al. (2000), p. 8, Hasbrouck/Seppi (2001), p. 401, or
Christie/Huang (1994), p. 307 for definitions of different variants of the bid-ask
spread.
3.1 Traditional Measures of Market Liquidity

175 (3.1) (3.2) (3.3) (3.4)

Proportional (percentage, relative) quoted spread = 2 (PA PB) / (PA + PB) Log
spread = ln(PA/PB) Effective Spread = |2Pt - (PA + PB)| Proportional effective
spread = |2Pt - (PA + PB)|/ Pt

Another spread-related measure is the amortized spread defined by Chalmers/Kadlec


(1998) as the half of the total daily effective spread, i.e., the sum of all
effective spreads in all transactions, scaled by the market value of the company at
the end of the day. It can be approximated as the proportional effective spread
times share turnover. Hasbrouck/Seppi (2001) proposed a further alternative, the
quote slope, defined as:292

Quote slope = (PA - PB) / (ln(NA) + ln(NB))

(3.5)

where NA and NB denote quantities (number of shares) traded at the given bid and
ask prices. In the graphical interpretation it is "the slope of the [...] line
connecting the bid and ask price/quantity pairs. If more quantity is added at
either the bid or ask, or if either quote moves closer to the other, the line
flattens and the market is more liquid."293 Empirical studies reveal that the bid-
ask spread is one of the determinants of returns in dealer markets.
Amihud/Mendelson (1986a, b) and many others294 stated a significant correlation
between spreads and stock returns interpreting this result as a liquidity premium,
i.e. a reward to the investor for holding an illiquid asset. The effect remained
after controlling for other possible sources of increased returns, including risk,
company size etc.,295 and it could also be observed for other publicly traded
assets.296 This led to the general opinion that the spread is indeed a good measure
of liquidity in organized markets. Nevertheless, it has its limitations.
Grossman/Miller (1988, pp. 628292 293

They also suggest a "log"-version of the slope defined as: ln(PA/PB) / (ln(NA) +
ln(NB)). Hasbrouck/Seppi (2001), p. 402. 294 See Amihud/Mendelson (1989),
Eleswarapu/Reinganum (1993), Kadlec/McConnell (1994), Eleswarapu (1997),
Chalmers/Kadlec (1998), or more recently Porter (2003). 295 The role of the bid-ask
spread was tested together with other factors (market and firm size, book-tomarket
ration, beta coefficient, investor recognition) by Amihud/Mendelson (1986b, 1989),
Kadlec/McConnell (1994), or Brennan/Subrahmanyam (1996). 296 See Amihud/Mendelson
(1991) for treasury securities or Dimson/Hanke (2004) for equity indexlinked bonds.
176

Chapter 3: Liquidity Measurement

630) point out that the difference between the bid and the ask is not quite
equivalent to the cost of providing immediacy services even if the effective spread
is used. This would only be the case if the dealer was able to close positions
immediately. However, positions opened with today's transactions are usually closed
in the nearer or further future. Thus, the "true" spread should be defined as the
difference between the present purchase/sale price and the future repurchase/resale
price, the latter one being uncertain. By ignoring this issue the time aspect of
liquidity is neglected. Furthermore, the empirically measured spread contains
several components that have more to do with the organization of market making than
with liquidity. These include, e.g., "seat" costs or limitations of feasible price
changes (minimal "ticks"). A more operational drawback of the bid-ask spread as a
liquidity measure is its limited applicability it can be computed only for
dealer-type markets. Although many important markets, like currency, bond, or money
markets are organized this way, many other relevant ones have other forms of
organization. In particular, no bids or asks exist in security auction markets.
Attempts have been therefore made to derive market breadth measures for these
cases. Among the most widespread ones is the implicit spread proposed by Roll
(1984).297 It is computed as:

Roll's implicit spread = 2 - cov( R i , R i +1 )

(3.6)

with cov(Ri,Ri+1) being the (negative) covariance between successive price changes
or returns (serial covariance). The proposition is based on the fact that there is
no possibility of a price decrease after a trade at a bid or a price increase after
a trade at an ask if the bid-ask spread is stable. E.g., if the last transaction
was a sale, than the next one can either also be a sale accomplished at the same
price or a purchase accomplished at a higher ask price. This asymmetry should lead
to a negative serial correlation of price changes if the observed interval is long
enough. Roll shows that the covariance of subsequent changes depends on the width
of the spread and equals -spread2/4. Reversing this logic, he proposes an implicit
measure of spread based on the return covariance, which can be computed in the
absence of dealers. However, there are at least two serious problems with Roll's
proposition resulting from the assumptions behind his model. The first one is the
efficiency of the analyzed
297

Choi et al. (1988) extent Roll's concept by allowing for serial correlations in
transaction types.
3.1 Traditional Measures of Market Liquidity

177

market. Only in efficient markets all information is always incorporated in prices,


and the width of the spread can remain constant. This also means that no adverse
information component is present in the implicit spread.298 Another requirement is
that price changes should be stationary during the observation period in order to
provide an unbiased estimation. Both these constraints can be regarded as fulfilled
for highly liquid assets, but they could be problematic for many less liquid ones.
Thus, despite numerous successful applications of Roll's implicit spread to
stocks,299 the possibility of its application to less efficient and less liquid
markets is highly disputable.

3.1.1.2. Market Depth


As discussed in section 1.1.1.2, market depth directly influences the consequences
of trading. Deep markets are those with many active traders, opposed to thin (or
shallow) markets, where only few traders act at a time. In consequence, an
individual investor may not be able to meet on sufficient supply or demand when
attempting to buy or sell larger quantities, and execution of a large order may
make a change in the market price (or in the bid-ask spread) necessary in order to
absorb the trade. Thus, a single transaction has a greater impact on the market if
liquidity is imperfect, and the price effect increases with the size of the
transaction. Thus, an adequate measure of this aspect of liquidity should consider
the gap between supply and demand, i.e., it should encompass not only the
accomplished transactions but also the transactions that could not have been
carried out due to insufficient market depth. However, extensive information about
the intentions of all market participants necessary for the construction of such a
measure is a serious hurdle.300 The most direct measure of depth in dealer type
markets is the quantity available for trading at the quotes; it can be expressed
either in currency units or as a number of shares.301 Such quantities are announced
by market makers together with bids and

298 299

300

301

See Glosten (1987). See Roll (1984), Choi et al. (1988), Haller/Stoll (1989),
Pagano/Roell (1990), pp. 79-83, or Iversen (1994), pp. 115-150, as well as
references in Iversen (1994), pp. 108-110. See Fernandez (1999), p. 10. A unique
study of market depth based on outstanding supply (i.e., the trading volume that
could not have been realized due to insufficient demand) is provided by Silber
(1975). The author utilizes the ability of the trading system on the Tel Aviv Stock
Exchange to provide this kind of data. See Chordia et al. (2000), p. 8,
Hasbrouck/Seppi (2001), p. 401, Huberman/Halka (2001), p. 165, Degryse et al.
(2004), or Bertin et al. (2005), p. 160.
178

Chapter 3: Liquidity Measurement

asks, and trading within these limits does not affect prices. Other often used
proxies available also for auction markets are the average trading volume and the
turnover.302 One can expect that balancing supply and demand is more difficult when
there is less trading (in absolute terms or in relation to market capitalization).
Some of the sellers or buyers will therefore be able to accomplish transactions
only by accepting less favorable conditions. In effect, the impact of a single
transaction on the market price should be higher. On the other hand, higher volumes
indicate better chances of finding a trading partner without affecting the price
level. However, both the quoted maximal transaction size and the level of trading
activity have serious limitations as depth measures. By using the first one, the
possibility of splitting larger transactions among multiple dealers is not taken
into account, and by using the latter one, the average transaction size is ignored.
In both cases, the resulting biases may distort the conclusions about markets'
relative liquidity. Nevertheless, several studies stated higher average returns in
times of lower trading activity interpreting them in terms of liquidity premia.303
Another popular measure based on return fluctuations due to trading is the
"liquidity ratio" the ratio of the (daily) trading volume to the (daily) price
change.304 Even a relatively low market activity leads to major price fluctuations
in illiquid markets; on the other hand, deep markets can absorb high trading
volumes without fundamentally unjustified price effects. Thus, the liquidity ratio
should be high in the former ones and low the in the latter ones. Though simple in
computation, this measure has several major drawbacks. One of them arises from the
fact that in many markets a lot of trading is between dealers. E.g., inter-dealer
trading constitutes up to 40%-45% of the total volume on the London Stock Exchange
and on NASDAQ, and it can even reach 85% in foreign exchange markets.305 This means
that in some cases, despite the seemingly high market activity, an "outside"
investor may find it difficult to finding a trading partner. Another possible
problem is the disproportional reaction of the price level to

302

303 304

305

See Silber (1975), Brennan et al. (1998), Datar et al. (1998), Jones (2002),
Chordia et al. (2001b), or Baker/Stein (2002) for applications of trading volume
and turnover as liquidity proxies. On the link between trading volume and liquidity
see Pagano (1989). See Datar et al. (1998), Brennan et al. (1998), or Jones (2002).
See Khan/Baker (1993), pp. 225-226, Cooper et al. (1985), p. 25, or Bernstein
(1987), pp.57-59. A reciprocal of the liquidity ratio is used by Porter (2003), pp.
7-9, and Brunetti/Caldarera (2004), p. 12. Amihud (2002, p. 34) additionally
adjusts the ratio by the time period to which it refers. See Viswanathan/Wang
(2004), p. 987-989, and the references therein.
3.1 Traditional Measures of Market Liquidity

179

the size of the trade. Although a correlation between the volume and the price
change is often observed,306 it is not proportional markets seem to react
relatively stronger to smaller transactions.307 Hence, when comparing two equally
liquid markets with different average transaction sizes, lower liquidity ratio of
the one with smaller transactions would result. To ease this problem, Marsh/Rock
(1986) suggest using the number of transactions instead of the trading volume.
Finally, the most severe problem with the liquidity ratio, as indicated by
Grossman/Miller (1988, p. 630), is the fact that the volatility of prices can and
does have many sources other than illiquidity. Frequent fundamental information
shared by all market participants moves prices without necessarily increasing the
trading volume. Fundamentally more volatile markets will therefore have higher
liquidity ratios. Market depth can also be measured as the order flow necessary to
induce a unit change in the market price or spread. This notion is used, e.g., in
the market microstructure model by Kyle (1985), where it is denoted as "". It is
also utilized in a number of theoretical and empirical studies in both dealer and
auction markets.308 The practical computation is usually based on an econometric
estimation trading volume is regressed on price changes. Brennan/Subrahmanyam
(1996) found a positive relation between Kyle's and average returns interpreting
it in terms of a liquidity premium. Proper interpretation of this measure may,
however, be biased by other factors affecting the relation between trading activity
and returns as discussed earlier.

3.1.1.3. Price Reversal


Resiliency refers to the dynamic aspect of trading (see section 1.1.1.2). It is
"the speed with which price fluctuations resulting from trades dissipate or how
quickly market clears order imbalances"309. A direct measure of resiliency,
indicated by Grossman/Miller (1988, pp. 627-628), is the correlation (or
covariance) between successive price changes. In illiquid markets, trading activity
induces changes of the price level (see former section). Since they are not
fundamentally justified, a counter-reaction should follow bringing the price level
back to equilibrium. In consequence, negative
306

307 308 309

See Karpoff (1987). The link between volumes and price changes is intuitive new
information induces more investors to trade resulting in stronger market reactions.
See Marsh/Rock (1986), as well as Bernstein (1987), pp. 58-60, for a comment. See
Glosten/Harris (1988), Hasbrouck (1991b), Foster/Viswanathan (1993). Fernandez
(1999), p. 10.
180

Chapter 3: Liquidity Measurement

serial correlations should be observed. Due to quicker reactions, the measured


correlation level should approach zero on liquid markets with large numbers of
traders. Grossman/Miller (1988) demonstrated this effect using a three period
market maker model and also stated the dependence of resiliency from the
variability of the market, hedging demand, and the number of market makers. These
theoretical considerations have been confirmed to some extent by empirical studies.
While positive short term (low order) autocorrelations between daily stock returns
have been often reported, correlations for longer terms (higher orders) were mostly
negative.310 Furthermore, Campbell et al. (1993) found a negative relation between
serial return correlation and trading volume, which seems to confirm the postulated
link to liquidity. In this context, the implicit spread proposed by Roll (1984) and
discussed in the former subsection can also be viewed as a resiliency measure as it
is directly based on serial covariance of returns. However, it has to be noted that
this measure is based on an entirely different idea. While resiliency is about the
speed with which markets reacts to changes caused by single transactions, Roll's
spread reflects the consequences of the mere existence of buyers' and sellers' on
the market. Nevertheless, since only series of effective prices and their
correlations can be observed in practice, differentiation between "normal" trading
within the (implicit) spread and "resiliency" trading resulting as a reaction to
liquidity-induced price movements will usually be impossible. Therefore, Roll's
implicit spread will inevitably have a resiliency component. Also the realized
spread (RS) defined by Huang/Stoll (1996) can be interpreted in terms of
resiliency. This empirical measure is defined as the difference between prices
observed within a time interval t provided the first price was an ask (RSA) or a
bid (RSB): RSA = - [(pt+t - pt)|pt = askt] RSB = - [(pt+t - pt)|pt = bidt] (3.7)
(3.8)

In liquid markets with quick reversals, realized spreads should be lower than in
illiquid markets where the price impact of a single transaction lasts longer.

310

See Fama (1965) or Conrad/Kaul (1988).


3.1 Traditional Measures of Market Liquidity

181

One of the more recent approaches to capture market resiliency is the empirical
price reversal suggested by Pastor/Stambaugh (2003).311 It is computed as the least
square estimate of the parameter l in the following regression:
rte+1 = + rt + l sign(rte ) t + t

(3.9)

with: rt

- return in period t - excess return over the market (market index) in period t -
price impact parameter - trade volume in period t - error term

e t

t t

Since excess returns resulting solely from the flow of orders are practically
absent (or are balanced almost immediately) in liquid markets, no influence of
trading volume should be observable there, and the estimate of l should be close to
zero.312 On the other hand, on an illiquid market, order imbalances leading to
contemporaneous excess returns are expected to be reversed in the future slower
reversals indicate lower liquidity. Hence, high values of l indicating strong
reversals occurring in subsequent periods are symptomatic for illiquid markets. A
problem common to all above measures is the choice of the time horizon necessary to
observe a reversal. Huang/Stoll (1996, pp. 327-32) argue that the considered
periods should be long enough to give an offsetting transaction an opportunity to
occur, but short enough to preclude noise resulting from the general return
volatility. This problem leads to a serious limitation in the practical application
of the discussed measures with respect to the comparability of different assets.
While one day seems to be appropriate for stocks, longer periods may be necessary
for other investments. The Market Efficiency Coefficient (MEC) proposed by
Hasbrouck/Schwartz (1988) may perform better in such cases.313 It is computed as
the ratio of the long term variance of logarithmic returns to their short term
variance. Liquid assets' returns should fluctuate
311

312

313

See also Porter (2003), pp. 5 ff. A related approach to analyze resiliency on the
basis of a simulation with a Vector Auto-Regressive (VAR) model is applied by
Degryse et al. (2004), pp. 9-11 and 17-19. The inclusion of the trading volume in
the regression is motivated by the results of Campbell et al. (1993) who state and
model the dependence between trading volume and serial correlations of stock
returns. See Pastor/Stambaugh (2003), p. 647. For comments see Bernstein (1987), p.
60.
182

Chapter 3: Liquidity Measurement

within relatively short periods remaining more stable over longer time horizons. On
the other hand, illiquid assets, due to the slow return reversion, should vary more
strongly over longer periods. MEC should therefore be low for the former ones and
high for the latter ones. Since the measure is based on two different time
horizons, it should be less sensitive to the above mentioned problem and allow more
general conclusions. 3.1.2. Application to Real Estate Markets

Liquidity measures reviewed in the previous section are (more or less) standard
approaches designed for various types of organized public markets or assets traded
in these markets. This environment is distinctly different from the one valid for
direct real estate investments as well as for most direct markets. A
straightforward application of depth, breadth, or resiliency based measures is
therefore in most cases not possible. Nevertheless, they have some desirable
advantages, which would also be welcome in the measurement of private markets'
liquidity: they are widely known and well researched, and they fit well in many
existing liquidity management systems. It might be therefore worthwhile to attempt
a translation of the "public" measures for the use in direct markets. This is done
in the following sections on the basis of the search model developed in Chapter 2.
Apart from the pure theoretical appeal, this step may be also interesting from the
practical point of view, providing analysts with measures they are familiar with.

3.1.2.1. Implicit Bid-Ask Spread


No bid-ask spread exists in the absence of market makers or dealers. This applies
obviously to direct real estate and most private markets there are no
institutions from which properties could be bought or to which they could be sold
immediately provided a premium or a concession was paid. Same applies to private
equity, wine, arts, and other assets traded on direct markets. Thus, there is no
direct possibility of observing or computing the spread. However, using the search
model presented in the previous chapter, an implicit measure of a hypothetical
spread is feasible. Its theoretical derivation is, in fact, simple and follows the
same logic as various inventory models with search, like the one by Stoll (1978).
If some hypothetical risk-neutral institution had the technical and financial
possibility of dealing on a real estate market, it would set bid and ask prices in
the same manner as it is done on security or currency markets. It
3.1 Traditional Measures of Market Liquidity

183

would be ready to buy at a price no higher than the expected expense that could be
achieved with the optimal search strategy only then the hypothetical dealer would
be indifferent between buying immediately from an investor and searching for a
seller by his own. Similarly, the immediate selling price should be no less than
the expected net receipts from a liquidation conducted according to the optimal
strategy. Hence, the implicit spread can be assessed as the difference between the
expected price paid and the expected receipts received at the respective optimal
reservation prices. The former one should typically lie below the average market
valuation, and the latter one should lie above it. Assuming that buy and sell
offers come from the same probability distribution, following implicit relative
bid-ask spread (Implicit Spread, IS) based on the real estate search model from
section 2.3 results:314
IS = max E( ) - max E( ) S B
S B

(3.10)

with: E( S ) =

- E( > S ) 1 - FR ( ) + S + - - + (1 - FR (S ))

E ( ) = B

+ E( < ) FR ( ) - B B +- - + FR ( ) B

S*, B* - optimal selling (S) and buying (B) reservation prices - relative rental
income - relative inspection /appraisal cost (referred to the mean offer value)
Reservation prices in this formula are set to maximize expected receipts (S*) or
minimizing expected expenditure (B*), which is the consequence of the assumed risk
neutrality of the hypothetical dealer. Although the idea behind this approach is
relatively straightforward, its practical realization meets with serious
difficulties. If an objective measure valid for any investor is to be derived,
optimal buying and selling prices also need to be objective. While the structure of
offers can be assumed to be the same for all investors, the choice of an
appropriate discounting factor constitutes a serious problem. It was argued in
section 2.3.1.3 that investor's personal opportunity costs should be applied. On
the other hand,
314

The expected net receipts are defined in section 2.3.2, formula (2.36); the
expected expense corresponds with the one derived in the section 2.3.3.7, formula
(2.46).
184

Chapter 3: Liquidity Measurement

when considering a professional (though hypothetical) risk neutral dealer, a risk


free or money market interest rate would be probably more in place. Also
observation costs should be set at a level appropriate for a dealer. The issue of
appraisal or inspection costs arises in this context. They have been ignored in the
initially analyzed real estate sale problem since the seller can be expected to
know the characteristics of her property. This is obviously inappropriate when the
purchase case is considered, as discussed in section 2.3.3.7. However, the
necessity of inspecting and valuing the property does not disappear in the sale
case either; it is only transferred on the other party of the transaction. Thus,
the question arises if the respective costs should be accounted for in an objective
hypothetical bid price. Their inclusion seems justified if the same offer
distribution is to be used for both sides of the market since prospective buyers
can be expected to correct their offers for appraisal expenses. An alternative
approach to computing the Implicit Spread may be borrowed directly from Roll
(1984). Since Roll's spread requires only the estimation of the covariance between
subsequent changes of transaction prices, it is significantly simpler to compute
than the search theory-based spread. The amount of transaction data necessary for a
precise estimation is, however, its main drawback. While easy to obtain in
organized public markets, reliable transaction prices are rather rare in the real
estate branch. Moreover, properties in the existing databases are usually only
partially comparable, and prices are reported in irregular intervals. Attempts to
estimate serial correlations would be therefore subject to substantial biases. A
problem immanent to any indirect estimation of the bid-ask spread is the issue of
information risk. As noted in the section 3.1.1.1, information asymmetry is one of
the components of the premium required by dealers who have to be rewarded for
expected losses arising from trades with insiders. With respect to real estate
markets, this aspect will most probably play a substantial role on the buyers'
(bid) side, but it will be relatively unproblematic on the sellers' (ask) side.
Unfortunately, this issue remains disregarded in Roll's implicit spread giving
another reason against the use of this measure with real estate investments. On the
other hand, the cost of inferior information is, at least partially, included in
the search-based approach by allowing for appraisal expenditures. Assuming that
appraisals reveal any hidden characteristics of properties allows their
interpretation as monitoring costs necessary to overcome information asymmetry.
3.1 Traditional Measures of Market Liquidity

185

3.1.2.2. Quick Sale Discount


An alternative concept related to the spread but based on a slightly different idea
is the "discount attending premature sale" proposed by Lippman/McCall (1986).315
For simplicity, it concentrates only on the seller's side of a transaction, though
incorporating the buyer's side is trivial. The measure reflects the cost of a quick
but suboptimal sale. As indicated in earlier chapters, illiquid assets are
characterized by the necessity of a more or less intensive search. By conducting it
according to a certain strategy, the outcome can be optimized; in particular, the
expected receipts can be maximized. An immediate sale to the first potential buyer
is therefore in most cases not optimal. The discount, which the investor is
expected to incur when she ignores the optimal search policy and insists on a quick
liquidation, may be used to measure liquidity. It is here denoted as the Quick Sale
Discount (QSD) and defined as follows: QSD = 1 - Vt/Vopt, with: Vt - value of the
search terminated within the first t periods Vopt - value of the optimally
conducted search (3.11)

A more specific definition of the QSD can be provided by applying the real estate
search model. For simplicity, quick sale can be defined as sale within one period,
i.e., sale to the first interested buyer. It is equivalent to setting an infinite
negative reservation price. The expected net receipts can be then derived by
computing the limit of the expression (2.37) for * approaching minus infinity. The
following QSD-formula results:
- + + ( - + )2 QSD = 1 - max E( > *) (1 - FR (*)) + * -
+ (1 - FR (*)) + - = 1- - + (1 - FR (*)) min - + * E( >
*) (1 - FR (*)) ( + - ) +

(3.12)

315

See also Mok (2002a), p. 12, and section 3.4.2 for the "utility version" of the
Quick Sale Discount.
186

Chapter 3: Liquidity Measurement

Perfectly liquid assets are marketable without a discount. Search is impossible or


pointless in this case, so the first available offer should be accepted. Highly
illiquid assets are characterized by high divergence of subjective valuations
making search worthwhile. Discounts for these assets should therefore be high. A
different version of the discount is the spread between the retail and the
wholesale price proposed by Krainer/LeRoy (1997 and 2002). The retail price is
defined as the effective realized sale price, and the wholesale price is the value
of the asset (house) to its owner just prior to the arrival of the successful
buyer. The term ,,wholesale " is used to indicate that the seller would be ready to
give up the house immediately without further search to a wholesaler (if one
existed) at this price. In other words, "this spread measures the capital gain the
seller experiences when a house sells"316, or equivalently "it equals the price
sacrifice a seller would have to accept in order to achieve immediate sale"317.
Krainer and LeRoy show that their spread is zero for perfectly liquid assets, and
that it increases with a decreasing frequency of offers. This measure is rather
difficult to interpret directly in terms of a search process, as it arises from an
equilibrium model designed by the authors. It seems, however, that the "retail
price" corresponds with the value of the accepted offer and the "wholesale price"
with the value of search. In terms of the search model, the expected value of the
former is E(P|P>p*), and the latter is equal to the maximum net receipts from
search (max E(G)) for a risk neutral investor. In the traditional search setting,
the difference between these terms is, however, equivalent with the periodical
search cost (see section 2.2.3, p. 120). An investor would be ready to give up the
next offer only if the expected additional gain would exceed the additional cost.
Thus, the measure of Krainer and LeRoy seems to be, in fact, a measure of search
costs.

3.1.2.3. Market Depth


Obviously, no direct measure of market depth referring to the maximal volume of
trading at a given bid-ask spread is applicable to direct investments. One could
try to proxy it as the average transaction size for which the Implicit Spread
defined above is still valid. A slightly more practicable alternative includes the
use of empirical turnover. In real estate markets, the latter can be understood as
the ratio of the overall trans316 317

Krainer/LeRoy (1997), p. 5. Ibidiem, p. 2.


3.1 Traditional Measures of Market Liquidity

187

action volume in a (sub)market to the total value of properties in this market.


High turnovers implicate higher liquidity; however, a correction for the number of
transactions or the size of a typical transaction is necessary. Given two real
estate markets with equal turnovers, the one with more frequent transactions, and
hence with lower average transaction sums, can be expected to offer better
liquidation chances. Ignoring this could lead to misleading results. For instance,
it is possible that in a certain area one of two shopping malls has been sold
generating a turnover of 50%, which would probably exceed the turnover in the local
residential housing market; but this would not mean that the market for malls was
more liquid than the market for houses. Thus, inflating the turnover ratio by the
size or by the number of transactions or even substituting the transaction volume
with the number of transactions seems reasonable. Even then, however, the ratio
would be only a rough proxy of market depth. Equally difficult are attempts to
construct an empirical measure of impact of large transactions on the price level.
The most straightforward difficulty is connected with the lack of sufficient data.
There is rarely a possibility of observing a sufficient number of transactions
within a short period of time to assess the price effect of a large trade. But also
the stickiness of real estate prices may complicate impact measurement; it is by
all means possible that a large transaction leads to a lower trading activity
rather than to an adjustment of subsequent prices, so that no price reaction would
be observable at all. Further difficulties arise from the relatively underdeveloped
market information systems in real estate markets. It is conceivable that a
substantial fraction of market participants learns about the unusually large
transaction with a delay, or even does not learn at all, so that market reactions
may be stretched over long periods of time and blurred by other events. Another
factor is the role of the construction industry, which also reacts to changes in
the market situation and may influence it by providing new properties. All in all,
direct empirical measurement of reactions of prices to trading activity, which is
difficult even for public markets, seems nearly impossible for real estate. Bearing
in mind the complications discussed above, it is still tempting to attempt a
definition of some kind of an implicit depth measure applicable to real estate,
preferably by using the search framework. The implicit liquidity ratio seems to be
the most promising reference point. Similarly to the original one, it should
measure the reaction of prices (spreads) to high trading volumes, and it should be
small in liquid markets
188

Chapter 3: Liquidity Measurement

capable of absorbing large trades without price impacts and large in illiquid
markets in which even a relatively small transaction affects the overall price
level. In the search framework, such reactions may be viewed in terms of changes in
the offer flow, especially in the distribution of offers. Consider the situation of
a seller willing to put up for sale an apartment in a neighborhood in which a large
sale transaction took place very recently e.g., a residential real estate trust
liquidated a portfolio of identical apartments. The pool of potential buyers faced
by the seller is smaller than usually, because many of those who considered buying
an apartment already bought one from the trust. Furthermore, assuming that the
trust sold its properties optimally, fully exhausting buyers' willingness to pay,
the apartments were bought predominantly by investors with high valuations. In
consequence the seller cannot expect as many unusually high offers for her
apartment as in the "normal" market state. This situation can be simplified by
assuming that the new offer distribution is the original one with a part of the
right tail cut off.318 Knowing the typical trading volumes and the transaction
frequencies on the market, it should be possible to assess the dimension of this
effect, and by applying the adjusted probability distribution of offers in the
search model, the corresponding reduction of the expected receipts from sale can be
estimated. The implicit liquidity ratio LRi could be then computed as the ratio of
the (proportional) change in the expected receipts due to the large transaction to
the volume of this transaction: LR i = E ( FR ,pre-sale () ) Transaction Volume E
( FR ,post -sale () ) - E ( FR ,pre-sale ( ) ) (3.13)

Note that this measure does not need to be based on any empirical observations of
large sales a hypothetical trading volume and its estimated effect on the offer
distribution can be used. This is advantageous if ratios for various markets are to
be compared as the same base volume can be applied.

318

Note that the effect of a recent large transaction on the distribution of offers is
analogous to the effect of setting a listing price (see section 2.3.3.5) in both
cases the right tail of the p.d.f. is cut off at a certain point. The only
difference is that the whole probability mass of the tail is allotted to the cut-
off point in the "listing price" case, while it is distributed over all remaining
offers in the "large transaction" case.
3.1 Traditional Measures of Market Liquidity

189

3.1.2.4. Market Resiliency


The resiliency measures presented in section 3.1.1.3 are mostly based on the
relation between subsequent returns. High serial covariance of daily stock returns
is interpreted as an indicator of low resiliency. This approach is obviously not
applicable to privately or even less frequently traded assets, and, thus, to higher
levels of illiquidity. The main problem is the already mentioned choice of the
proper time window for observing return reversals. While liquid stock or currency
markets react within minutes, so that one day can be already viewed as a "long
period", it is clearly too short to register any response in a real estate market.
As a result, short term return covariance at a zero level can be expected for most
property markets, which is definitely not due to their extremely high liquidity.
However, even with adequately long measurement periods, it is rather doubtful that
serial covariance can be a useful resiliency measure for privately traded assets.
Its unambiguous interpretation when comparing different markets seems hardly
possible. Imagine, for instance, that a very low covariance was measured for
monthly returns in the (real estate) market A but a very high negative one in the
market B. Without a deeper analysis it can only be stated that the reversal period
in A is other than one month; lower covariance may result from the fact that this
time interval was too short to allow any reaction or that the reaction was much
quicker and was already overlaid with other sources of volatility. This problem is
slightly less severe for Hasbrouck and Schwartz's (1988) Market Efficiency
Coefficient since two time windows are used there, but it does not disappear
entirely. In view of the problems connected with the use of serial correlations in
private markets, time needed to balance a large transaction seems to be a more
reasonable alternative. If a typical reaction time exists, it should be possible to
identify it by analyzing autocorrelations of various orders and, thus, various time
windows. The window length for which the highest negative correlation is observed
can be interpreted as the time required to reverse liquidity induced price
fluctuations. Markets with short reaction periods can be considered as more
resilient than those with longer ones. However, though methodically very appealing,
this concept is rather difficult to apply for most real estate markets. The reason
is again the lack of sufficient data. With annual or at best monthly indexes, no
reasonable market reaction periods can be determined weekly data seem to be the
minimum for this purpose. Another problem, already mentioned in the previous
section, is the possibility that not the price level but the trading
190

Chapter 3: Liquidity Measurement

volume reacts to liquidity events and is reversed. Thus, an additional analysis of


volume autocorrelations might be necessary. A further bias may arise from the
existence of real estate cycles, which also induce (positive) autocorrelations of
market variables. In consequence, even if the application of reaction times to
proxy real estate markets' resiliency was possible, it would be a very imprecise
measure. An alternative approach to estimate the resiliency of real estate markets
is the use of offer arrival rates.319 Since resiliency stands for the dynamic
aspect of liquidity, markets with more intensive offer flows should also react
faster to short term, unexpectedly high trading volumes. However, this approach
does not entirely capture the idea of resiliency. Not the arrival rate itself but
rather the reaction of the arrival rate to the possibilities of profitable trading
arising from fundamentally unfounded price movements is of interest. As discussed
in the previous section, high sale volumes take buyers with higher reservation
prices out of the market and result in (contemporaneous) changes of the offer
distributions. In effect, the achievable gains from searching fall, and sellers
should correct their reservation prices in response. This again opens for buyers
the possibility of acquiring properties below their usual prices. The offer arrival
rate should increase in such situations, as even those potential buyers who would
not attempt a purchase under "normal" conditions are attracted. Back on the
sellers' side, an increased offer arrival rate may result in lower opportunity
costs making up for the changes in the offer distribution and driving the expected
receipts from sale, reservation prices, and finally also the transaction prices to
higher levels. Of course, this effect is only temporary, and the initial situation
is restored as the offer distribution comes back to normal. It follows from the
above reasoning that the price reversal is initiated by the adjustment of the offer
arrival rate. A possible measure based on this concept could include, e.g., the
sensitivity of expected sale receipts to changes in the offer arrival rate.
Unfortunately, there is no easy way of implementing this idea in the search model,
as it assumes strategic trading on both sides of the market; the model utilized in
this work allows for strategic behavior only on one of the sides. Changes in the
arrival rate expected within a certain period of time after the initial transaction
would therefore need

319

The role of the offer arrival rate (in terms of a Poisson process) for various
aspects of public markets' microstructure, including liquidity, is modeled by
Garman (1976) and Amihud/Mendelson (1980).
3.2 Time- and Probability-Based Measures

191

to be estimated empirically. Considering the amount of information about market


activity necessary for such estimation, it seems rather impossible to conduct in
practice. However, even if this problem could be overcome, changes in the offer
distribution resulting from the arrival of new buyers would still remain
disregarded. Thus, also this approach gives little hope for a practicable
resiliency measure based on techniques developed in this book.

3.2.

Time- and Probability-Based Measures

Illiquidity measures presented in the former section were related to the


traditional approaches concentrating typically on various aspects of liquidity in
public markets. Among liquidity measures used in the literature for non (or not
necessarily) public investments, those based on the chance of successful
liquidation or on the time required for liquidation are most popular. Contrary to
the traditional ones, they focus on the liquidity of assets rather than the
liquidity of whole markets, and they tend to concentrate only on the possibilities
of sale disregarding the purchase case. 3.2.1. Probability of Sale and Time on the
Market

The probability of sale (PoS) is a very intuitive measure of liquidity.320 It


refers to the chances of a successful liquidation of an asset within a given span
of time. Clearly, it should be higher for more liquid assets. Time-on-the-market
(ToM), also referred to as time-till-sale or marketing duration, is directly
related to the probability of sale.321 It is defined as the time it takes on
average to sell an asset, or the time the asset remains on the market. Liquid
assets can be marketed quickly, illiquid ones require more time; hence, ToM
decreases with liquidity. The ease of interpretation is probably one of the reasons
for the popularity of this measure among researchers. It has been estimated from
empirical data using econometric models322 as well as derived from formal market
models323. The link between PoS and ToM is straightforward higher probability of
sale should on average lead to shorter liquidation periods. However, while ToM can
be defined either as the expected future marketing time (ex ante approach) or as
the
320

321

322 323

See Haurin (1988), pp. 406-407, Krainer/LeRoy (1997), pp. 5-7, Krainer (1999), pp.
17-19, Krainer (2001), pp. 42-45, Krainer/LeRoy (2002), pp. 232-233. Some
researches go even further and set an equivalence mark between liquidity and ToM.
See Fisher et al. (2004), p. 241. See Miller (1978), Asabere et al. (1993), Forgey
et al. (1996), or Anglin et al. (2003). See Lippman/McCall (1986) or Krainer
(1999).
192

Chapter 3: Liquidity Measurement

average marketing duration observed in the past (ex post approach), PoS makes sense
only as an ex ante measure. Note that even if sale probabilities are derived from
past transaction frequencies, they are, in fact, estimations of (implicit) past ex
ante sale probabilities. An important aspect in the research on the marketing time
on real estate markets is its relation to the listing price and to the realized
sale price. It has been empirically verified by numerous researchers and
interpreted in terms of a price-time locus specific for each market.324 The
observed slope of the locus is usually positive the listing price and the sale
price increase with ToM.325 This result is in line with the traditional view of
liquidity as the positive dependence between the duration of the liquidation
process and the realized value (see section 1.1.1.1). Which point of the locus is
chosen by an investor depends on her preferences more time concerned investors
prefer shorter ToMs, and more price concerned ones choose longer ToMs.326
Expressing time preference in form of a discounting rate leads straight to the
definition of liquidity as the selling time corresponding with the highest
achievable present value of liquidation discussed in section 1.1.2. According to
it, investors with higher time preference choose quicker selling procedures than
less time concerned ones, but they do it at the cost of a lower nominal sale price.
Further evidence on the link between ToM and liquidity arises from the analysis of
the determinants of marketing duration. One of the central statements is that the
duration of search and ToM increase with property's atypicality.327 The more
unusual the property is, the more difficult it is to find a buyer. This again
complies with the notion of illiquidity as the result of heterogeneity of asset's
valuations among potential buyers (see section 1.2.4), which is higher for less
typical properties.

324

325

326

327

See Belkin et al. (1976), Trippi (1977), Miller (1978), Asabere et al. (1993),
Forgey et al. (1996), Glower et al. (1998), or Anglin et al. (2003). Cubbin (1974)
found an opposite direction of the relationship between the selling price and the
speed of sale on the analyzed housing market; he admitted, however, that this
should not occur in a normal market situation. Anglin (2003) studies the
consequences of market changes on investor's choice of the preferred ToM
decomposing the total effect in a liquidity and a value component. The first one
results from the time preference and the second one from the price preference.
Cubbin (1974), pp. 183 ff., reverses this logic theorizing on the consequences of
investor's choice for the market. See Haurin (1988), Forgey et al. (1996), or
Glower et al. (1998).
3.2 Time- and Probability-Based Measures

193

Both PoS and ToM can be easily interpreted in terms of a search model. The former
one is nothing else than the probability of receiving an acceptable offer within
some time horizon, i.e., the probability that an offer above the reservation price
arrives during this time period. The simplest approach is to define the time
horizon as the number of reviewed offers (i). Using the basic search framework, the
following PoS formula results:328
PoSi = (1 - F(p*)) F j-1 (p*) =1 - Fi (p*)
j=1 i

(3.14)

Defining the time horizon in time units and assuming random arrival times
complicates the computations since the number of offers (I) within the considered
time period ( T ) is random in this case. The respective PoS formula is then as
follows:329
~ ~ PoST = 1 - Fi (p*) Pr(I = i T)

i =0

(3.15)

In this context, ToM corresponds with the duration of search and is related to the
time horizon in the definition of PoS.330 The expected ToM is, thus, equivalent to
the expected duration of search. In the basic models with discrete time, like those
discussed in sections 2.2.3 and 2.2.4, the duration of search corresponds with the
number of offers and is determined by the reservation price the expected duration
of search as well as the "discrete" time-on-the-market (ToMD) is simply the
reciprocal of the probability that an acceptable offer arrives:331, 332

328

329

The definition of the "probability of purchase" is analogue; it is the probability


of finding a property with the demanded price lying below the reservation price.
Also other considerations in this section can be applied to the buyer's search for
the best seller. In the real estate search model with a Poisson offer arrival
process, the probability of receiving i ~ offers within a time span of T is
determined by the Poisson probability function, which is defined ~ ~ ~ as P(I = i
T) = e -T i T i i! with being the offer arrival rate. Note that ToM refers to
the exact duration of the liquidation process, while the time horizon in the
definition of PoS is the maximal liquidation time. ToM defined as the number of
offers is, in fact, identical with the expected duration of search E(D) defined in
section 2.3.1.2. See also FN 218. See Cubbin (1974), p. 178, Haurin (1988), p. 399-
400, or Glower et al. (1998), p. 723. Krainer/LeRoy (1997), pp. 5-6, Krainer
(1999), p. 18, and Krainer/LeRoy (2002), p. 232-233, define ToM as the expected
remaining marketing duration, which corresponds with the reciprocal of the hazard
ratio defined in the next section.
330

331

332
194

Chapter 3: Liquidity Measurement

E(ToM D ) =

1 1 - F(p*)

(3.16)

The unit of E(ToMD) in the above formula is the number of offers reviewed until an
acceptable offer arrives. The corresponding duration of search expressed in time
units depends on the lengths of the time periods between offers, which can be
viewed either as fixed (discrete approach) or as random (continuous time
framework). With being the frequency of offers (fixed or expected in terms of the
mean of a Poisson process), the "continuous" ToMC is defined as follows:
E (ToM C ) = E (ToM D ) /

(3.17)

The possibility to apply the search-based ToM for liquidity measurement was
indicated already by Miller (1978) and extensively formulated by Lippman/McCall
(1986).333 The latter authors propose the optimal expected selling time as a
liquidity ~ measure. The optimal duration of search ( t ) for a risk neutral
seller is defined as:334

~ ~ ~ ~ E (G t *) = max E (G t ) : t T

(3.18)

~ The variable t * is random, and its expected value is used as the indicator of
asset's ~ liquidity.335 It is easily noticed that E ( t *) is equivalent to the
expected duration of

search (or ToMD) resulting at a reservation price which maximizes the expected net
receipts from sale.336

~ E ( t *) =

1 1 - F(p ) opt

(3.19)

Lippman and McCall demonstrate the compliance of their measure with a number of
various notions of liquidity. In the first place, they re-interpret Keynes' concept
of a
333

334

335

336

Further applications of the search framework for the analysis of ToM can be found
in Haurin (1988), Forgey et al. (1996), Glower et al. (1998), Krainer/LeRoy (1997,
2002), or Krainer (1999, 2001). Note that the optimal duration of the search arises
from the optimal stopping rule applied during the search and is therefore a random
variable. See Lippman/McCall (1986), p. 46-47. The authors choose the mean of ~ *
but indicate that also other distributional parameters can be t used for this
purpose. See Lippman/McCall (1986), FN 10. See also the discussion of the
equivalence between the expected duration of the search and the reservation price
in section 2.3.5.
3.2 Time- and Probability-Based Measures

195

liquid asset being "more certainly realizable at short notice without loss"337 as:
"has a higher probability p of being sold in one period in accord with the optimal
policy"338. It follows from the equation (3.19) that a shorter expected search
duration implies a ~ higher sale probability (1-F(popt*)), so lower E ( t *) means
higher liquidity. The measure is also positively correlated with investor's time
preference rate. This is in line with the role of investor's impatience for the
perceived level of liquidity: the more pressing the need for money is, the more
disturbing the inability of quick liquidation becomes.339, 340 Furthermore, the
predictability of the realized price, understood as the divergence of opinions
about asset's value, and the thickness of the market, understood as the frequency
of offers, are positively related to the optimal expected marketing time. However,
the latter statement holds only if either the interest rate is near zero or the
frequency of offers is very high.341 Finally, the authors provide the proof of a
link between their measure and the discount due to prompt liquidation (as derived
in section 3.1.2). Thus, a measurement concept as simple as the optimal ToM can
encompass a variety of different approaches to liquidity. 3.2.2. Proportional
Hazard Ratio

Kluger/Miller (1990) propose a measure of liquidity based on Cox's proportional


hazard model.342 This methodology is generally a useful tool for describing
durations in various processes.343 The concept of the proportional hazard ratio
(PHR), also denoted as the odds ratio, is closely related to the probability of
sale; the measure provides, however, a relative rather than an absolute notion of
liquidity.
337 338 339

340

341

342 343

Lippman/McCall (1986), p. 46 after Keynes (1930), p. 67. Lippman/McCall (1986), p.


46. An analogous result can be derived for the real estate search model: a higher
discounting rate leads to a lower expected net receipts, a lower reservation price,
and finally, according to the equation (3.16), to a higher expected duration of
search. This way of reasoning is not strictly correct as it ignores the adjustment
of the optimal reservation price resulting from changes in the discounting factor.
However, as Lippman/McCall (1986), pp. 46-47, show, the conclusion also holds when
the search strategy is varied. See also the discussion of the ambiguous effect of
changes in the frequency of offers on the value of the search in the real estate
search model in section 2.3.2. See also Kluger/Stephan (1997) who apply the
proportional hazard measure of liquidity on stocks. Hazard and proportional hazard
models have been used for the analysis of ToM by Genesove/Mayer (1994), pp. 9-15,
Anglin (1997), pp. 579-581, Glower et al. (1998), pp. 728-731, Krainer (1999), pp.
19-20, or Pryce/Gibb (2006), as well as for the analysis of other duration problems
within real estate, e.g., mortgage defaults (Vandell et al., 1993, and Simons,
1994) or investment property holding periods (Collett et al., 2003).
196

Chapter 3: Liquidity Measurement

The starting point is the hazard function, defined as the conditional probability
of sale ~ ~ in period t provided that the property has not been sold yet. If f
( t ) and F( t ) are the ~ p.d.f. and the c.d.f. of the selling time (search
duration) t , respectively, than the hazard ~ function h ( t ) is defined as:344 ~
h( t ) = ~ f(t) ~ 1 - F( t ) (3.20)

The idea of the proportional hazard ratio is based on the constant relation between
hazard functions of various property types. This means that the hazard function for
each ~ specific submarket can be derived from the original function h ( t ) common
for the global real estate market or, in simple words, that the relation between
the probabilities of selling properties in markets A and B, provided they have not
been sold yet, remains constant over time. If the house A is twice as easy to sell
as the house B in the first week, than it is also twice as easy to sell in the
second week. The relation between hazard ratios depends only on the characteristics
of markets. Kluger and Miller assume a functional dependence of the market-specific
hazard function from some market characteristic X (e.g., number of bedrooms, lot
size, neighborhood quality etc.) with the following baseline hazard function:

~ ~ h ( t , X) = e bX h ( t )

(3.21)

The parameter b defines the effect of X on the hazard function. The resulting
relation between hazard functions (proportional hazard ratio, PHR) of markets
delimited by the characteristics X1 and X2 (e.g., one- and two-bedroom houses) is
as follows:

PHR (X1 , X 2 ) =

~ ~ h ( t , X1 ) eX1 h ( t ) = X = e( X1 -X2 ) ~ h ( t , X 2 ) e 2 h (~ ) t

(3.22)

344

The hazard function can also be defined in terms of the standard search model with
respect to the number of observed offer (i):

h (i) =

1 - F( p*) 1 - FR ( *) = i F i (p*) FR (*)

Since a geometric process is considered here, it an increasing exponential


function.
3.3 Measures of Liquidity Risk

197

An interesting and practically relevant feature of this relation is its


independence from the form of the baseline hazard function. The only required
parameter is b, which can be estimated from empirical data using the maximum
likelihood approach.345 It always refers to a certain characteristic of properties
meaning that a separate estimation is necessary in each case. As mentioned, PHR is
closely related to ToM. In fact, the relative sale probability corresponds directly
with the relative expected remaining marketing time. This means that an odds ratio
of, e.g., 2 indicates that the conditional probability of sale of the first
property is twice as high as that of the second property; at the same time, it says
that the second property is expected to remain on the market twice as long as the
first one. Estimation of ToM from a known PHR is, however, not possible unless the
baseline hazard function is either known or assumed. ToM can be then computed using
the formulas (3.20) and (3.21). One of the main advantages of the proportional
hazard ratio is the simplicity of its application. After estimating b-parameters
for all relevant characteristics, relative liquidity of submarkets delimited
according to any arbitrary set of criteria can be computed on the spot. Apart from
quantitative characteristics, like size, number of rooms, or age, also qualitative
criteria, like location quality, architectonic style, or social structure, can be
incorporated as dummy variables. Furthermore, it is also possible to use biased
data for the estimation of b-parameters, provided the same bias is present in every
sample (i.e., with respect to every characteristic). The fact that only relative
measurement of liquidity is possible with PHR may be viewed as a drawback; however,
in many cases the comparison of liquidity levels for different markets is all an
investor requires.

3.3.

Measures of Liquidity Risk

As discussed in Chapter 1 in section 1.1.2, one of the most important and often
underestimated aspects of liquidity is the uncertainty of the liquidation value.
This issue is particularly important with respect to privately traded assets for
which no organized market structures exist. Due to the heterogeneity of the asset's
valuations among market participants, an investor cannot be sure about the
effective receipts from sale even if she allows for sufficiently long liquidation
time. In fact, it is this uncertainty that
345

For the description of the estimation procedure see Kluger/Miller (1990), p. 150.
198

Chapter 3: Liquidity Measurement

constitutes the main problem when investing in illiquid assets. Therefore, it is


necessary to extend the measurement of liquidity by the risk aspect. There is only
limited literature on liquidity risk measurement. It operates mostly on the level
of market liquidity and concentrates on organized public markets. As already noted
in section 1.1.2, most of the popular approaches address the risk arising from
changes in the market-wide liquidity level (exogenous risk) and from price
reactions to large transactions (endogenous risk). Apart from several variance
based methods, incorporation of liquidity in the Value at Risk (VaR) concept is
most frequent. Finally, several more recent papers consider liquidity as a factor
that indirectly increases investment risk by affecting volatilities and
correlations of returns346. All of these approaches refer, however, to public
markets liquidity risk of real estate and other privately traded illiquid assets
remains an open issue. In view of the importance of the risk aspect for the
rational management of liquidity, the state of research on this subject is clearly
insufficient. Therefore, the focus of the section is on the derivation of possible
approaches to capturing liquidity risk associated with investments in real estate
and other privately traded assets. In particular, the necessity to search for a
buyer when selling these assets should be adequately taken into account. The
classical principles of risk measurement, as they are known from the finance
literature on market risk, have been chosen as the reference point. They are
presented at the beginning of the section. The discussion of the most popular
measures including volatility, lower partial moment, default probability, and Value
at Risk follows. The search theoretical approach is applied in each case to derive
practical measures of liquidity risk. 3.3.1. Principles of Risk Measurement

Measurement of risk has been discussed by various researchers in uncounted papers.


In general, its purpose is to determine the grade of uncertainty about reaching the
goal intended with an investment. Thus, one can only speak of risk when there is
more than one possible outcome of an investment and at least one possible scenario
can be interpreted as missing the goal. Measurement is only possible when dealing
with risk in the narrow sense, i.e. when objective or at least subjective
probabilities can be assigned to the alternative scenarios. Otherwise, in the state
of total incertitude, no useful state346

See Buhl et al. (2002), Brunetti/Caldarera (2004), or Budhraja/de Figueiredo


(2005).
3.3 Measures of Liquidity Risk

199

ment can be made about the level of risk associated with an investment making
rational management of this aspect literally impossible. The latter case is
therefore excluded from further considerations.347 The numerous existing approaches
to risk measurement can be divided into qualitative and quantitative ones. The
former are usually based on a verbal description of the situation, including
identification of different sources of risk and their consequences. The active role
of an analyst, whose opinion is the main judgment criterion, is especially
characteristic for these measures. One of their advantages is the possibility of
allowing for soft criteria, which are difficult to measure or even to express in
simple words or symbols. Furthermore, the result can be adjusted according to the
analyst's personal experience or even unpronounced feelings. The possibility of
profiting from the cumulated knowledge of highly qualified specialists is one of
the main strengths of qualitative measures. However, the "human factor" is at the
same time the source of their weaknesses. The quality of the results depends on the
abilities of the analysts and may vary from one measurement to another. For the
same reason, different qualitative measures may be difficult to compare, especially
when they originate from different institutions applying different standards.
Finally, qualitative measures are difficult to implement in formalized investment
decision systems, which require that risk is expressed with a figure calculable for
single investment as well as for portfolios. Mainly for the latter reason
qualitative liquidity risk measurement is not further followed in this book. In
contrast, quantitative approaches to risk measurement usually utilize statistical
parameters of a random variable corresponding with the goal of the investment (goal
variable). This implies that the goal can be quantified (i.e., expressed as a
figure) and that probabilities can be assigned to its values. However, even with a
known probability distribution of the goal variable, it is still unclear which of
the numerous theoretically computable statistics is most appropriate. The choice
depends greatly on the precise definition of risk. Since investors not always mean
the same when they include "risk" in the catalogue of their decision criteria,
specification of the actual meaning of this word is of key importance in
determining the proper measure. It is straightforward that a different approach
will be apt depending on the individual altitude of the deci-

347

See FN 159.
200

Chapter 3: Liquidity Measurement

sion maker. It follows that the existence of a universal risk measure is


practically impossible.348 Figure 3-1 summarizes different possible understandings
of risk and relates them to the probability distribution of the underlying
variable.349 The arrows indicate the directions of the deviations from the
reference value relevant for the investor. A point target (a) means that any
variation is interpreted as risk. The desired result is precisely specified and the
investor fears both under- and overshooting it; the intensity of the perceived risk
increases with the distance from the target. An interval target (b) is similar in
its nature; however, the objective is to reach a span instead of a single value of
the goal variable. With a minimum requirement set as the target (c) the investor
expresses her pursuit of reaching certain minimal result; only underperformance is
viewed as risk. Finally, an investor considering any result lower than the maximum
possible one as negative follows the "maximization target" (d). Further possible
ways to understand risk can be enumerated. Generally they can be classified into
two categories: symmetric approaches, in which risk is defined as any deviation
from the selected target, and asymmetric approaches, in which deviations in only
one direction are regarded as risk. Analogue classification applies to risk
measures; one distinguishes between symmetric, variation based risk measures and
asymmetric, one-side risk measures. The latter ones are further decomposed into
downside and upside risk measures, depending on the direction of deviations they
refer to.

348

349

On the discussion of various notions of risk see Kupsch (1973), 26-33, Levy/Sarnat
(1984), pp. 235-239, or Schmidt-von Rhein (1996), p. 159-165, as well as the
literature cited there. The presentation in this paragraph is based on Schmidt-von
Rhein (1996), p. 165-168.
3.3 Measures of Liquidity Risk

201

A. Point Target Risk = the possibility of missing a target t Probability

Goal Variable

B. Interval Target Risk = the possibility of missing an interval (tmin, tmax)


Probability

tmin

tmax

Goal Variable

C. Minimum Requirement Target Risk = the possibility of underperforming a minimal


target tmin Probability

tmin

Goal Variable

D. Maximization Target Risk = the possibility of underperforming a maximal


achievable tmax Probability

Goal Variable

Figure 3-1: Alternative notions of risk referred to the probability distribution of


the goal variable350

350

Based on Schmidt-von Rhein (1996), p. 167.


202

Chapter 3: Liquidity Measurement

The different notions of risk and the respective types of risk measures defined
above are very general, without reference to any concrete goal variable. In the
investment practice they are usually applied to returns or asset values; however,
they can also be applied to liquidation receipts or to purchase expenses in the
same manner. In this sense, a symmetric notion of liquidity risk encompasses any
deviations from some targeted net receipts or expenses and an asymmetric notion is
equivalent with receiving less or spending more than intended. Thus, depending on
the precise definition of risk, a number of different measures are possible.
Several alternatives are proposed in the following sections. Of course, they do not
exhaust even a fraction of all possibilities; however, they correspond with the
most popular measures of market risk used in the investment theory and praxis.
Volatility is an example of a variation based measure; default probability,
semivolatility, and Value at Risk are downside risk measures. Each of them measures
liquidity risk from a slightly different perspective and is appropriate for a
different type of investor. 3.3.2. Volatility

Volatility is doubtlessly the most popular statistical measure of risk. Although


most frequently applied to returns, it can also be computed for any other
investmentrelevant random variable. Low volatility means that the variable's values
are not expected to deviate substantially from its expected value; high volatility
indicates that they will probably vary very strongly. Formally, volatility
corresponds with standard deviation, i.e., the square root of variance: S( X ) = V
(X ) = E ( X - E (X )) 2 =

(X - E(X))

f ( X ) dX

(3.23)

Variance, which is a risk measure equivalent to volatility, can be alternatively


computed as variable's square expected value minus the expected value of the
squared variable:
V(X) = E(X 2 ) - E 2 (X)

(3.24)

Volatility is a symmetric measure; it measures the level of uncertainty referring


to both the risk of performing weaker than expected (downside risk) and the chance
of outper-
3.3 Measures of Liquidity Risk

203

forming the expectations (upside risk). As long as the distribution of the goal
variable is symmetric, like the normal distribution, the deviations from the mean
in both directions are equally probable and volatility is proportional to both the
upside and the downside risk. Multiple volatility corresponds then with a certain
confidence interval determining the range of variable's fluctuations around the
mean that is not exceeded with a given probability. However, this property does not
hold as soon as an asymmetric distribution of the goal variable is considered. As
soon as the probabilities of performing better or worse than expected are not
equal, it is possible that the "wrong side" of uncertainty is measured. This
drawback of volatility is discussed more thoroughly in the next section. Volatility
is used in the literature mainly for measuring exogenous and endogenous liquidity
risk of public markets. With respect to the former one, it is usually based on
market breadth or depth measures. This approach is applied to the bid-ask
spread,351 to trading volume or turnover,352 or to the liquidity ratio353. In fact,
as soon as a concrete measure of market liquidity is agreed on, its volatility can
be used to assess (exogenous) liquidity risk.354 In the measurement of endogenous
liquidity risk, volatility (or variance) is usually applied to the realized
liquidation value or to the liquidity cost. In either case, the source of
uncertainty is the change of the market price resulting from executing a (large)
order.355 However, practically all of the above approaches use volatility to
correct the overall Value at Risk rather than as a stand-alone measure; they are
therefore discussed more thoroughly in section 3.3.3.3. A related but more general
application of volatility as a liquidity risk measure has been introduced by
Garbade/Silber (1979). The prime goal of the paper is to demonstrate the influence
of the clearing frequency on liquidity risk. For the purpose of this study, the
authors define liquidity risk as the variability of the difference between the
equilibrium value of an asset at the moment of the decision to trade and the
equilibrium value at the moment the transaction price is paid; variance is used to
quantify this varia351

352 353 354

355

See Bangia et al. (1999), Duffie/Ziegler (2003), Jorion (2001), pp. 343-351, Le
Saout (2002), Franois-Haude/Van Wynendaele (2001), or Angelidis/Benos (2005). See
Chordia et al. (2001a). See Acharya/Pedersen (2005). E.g., Pastor/Stambaugh (2003)
analyze the variability of their reversal measure (see section 3.1.1.3) and
interpret it as liquidity risk, though they do not quantify it explicitly with
variance or volatility. See Almgren/Chriss (1998, 2000/2001), Dubil (2002, 2003a),
or Moorthy (2003), pp. 32 ff.
204

Chapter 3: Liquidity Measurement

bility. It is derived on the basis of a formal market model developed by the


authors and is a function of the variance of traders' reservation prices, the
variance of changes in the equilibrium value of the asset, the rate of
transactions' exposure to the market, and the clearing frequency. By referring
directly to realized prices, this approach is not limited to organized markets and
can be applied for any type of market organization. Hence, the idea formulated by
Garbade/Silber (1979) can be used to develop a volatility-based liquidity risk
measure for privately traded assets. The search theoretical approach provides a
method for computing the volatility of realized transaction prices or sale proceeds
even without the existence of an organized market. In particular, the real estate
search model can be used to derive the volatility of relative net receipts from
selling property investments.356 For the derivation of the variance formula, it is
convenient to recall the equation (3.24). The variance of relative sale receipts
can be expressed using the expected receipts and the expected square receipts:

V ( ) = E ( 2 ) - E 2 ( )

(3.25)

Since the expected net receipts formula has been already derived for the real
estate search model (see formulas (2.36) and (2.38)), derivation of the expected
square receipts remains.
j j -( - ) t k -( - ) t k k =1 k =1 E( 2 ) = E (1 + A Tj ) e + Tj e
< * j j

(3.26)

As assumed in section 2.3.1.5, the expected value of the market uncertainty factor
equals 1, and its standard deviation equals A. Following the same logic as in the
calculation of the expected receipts, i.e., applying the formula for the sum of an
infinite geometric series, yields the following result:357

356

357

An analogous approach is used by Mok (2002a, b). This is, to my best knowledge, the
only attempt to use the volatility of sale receipts with respect to non-publicly
traded assets. See section 3.4.2 for a closer discussion of this approach. See
Appendix A.5 for the full derivation. Notice that the formula is valid only under
certain conditions, especially the nominators must not be negative.
3.3 Measures of Liquidity Risk

205

E ( 2 ) = +

E ( 2 > *) X 2 (1 - FR ( *)) 1 - X 2 FR (*)

2 E( 2 > *) Z 2 (1 - FR (*)) A

(1 - X 2 FR (*))3 2 E( > *) (1 - FR (*)) Y2 + (1 - X1 FR (*)) (1 - X 2


FR (*)) 2 (Z 2 (1 - X 1 FR (*)) + 2 Y1 Y2 FR (*)) + (1 - X1 FR (*)) (1 - X
2 FR (*))
with: X1 = e - t (- ) e -t dt =
0

2 2 E ( 2 > *) Y22 (1 - FR (*)) FR ( *) A

(1 - X 2 FR (*))2

(3.27)

( - ) +

X 2 = e -2 t ( - ) e -t dt =
0

2( - ) +

Y1 = te - t (-) e -t dt =
0

(( - ) + )2
(2( - ) + )2

Y2 = te -2 t (-) e -t dt =
0

Z 2 = t 2 e -2 t (-) e -t dt =
0

(2( - ) + )3

Hence, the variance of the relative net receipts from search equals:
V ( ) = + E ( 2 > *) X 2 (1 - FR ( *) ) 2 E ( 2 > *) Z 2 (1 - FR ( *) ) +
A 1 - X 2 FR (*) (1 - X 2 FR (*))2

(1 - X 2 FR (*))3 2 E ( > *) (1 - FR ( *) ) Y2 + (1 - X1 FR (*)) (1 - X 2


FR (*)) 2 (Z 2 (1 - X1 FR (*) ) + 2 Y1 Y2 FR (*) ) + (1 - X1 FR (*)) (1 -
X 2 FR (*)) 2 E ( > *) X1 (1 - FR ( *) ) + Y1
- 1 - X1 FR (*)
2 2 E ( 2 > *) Y22 (1 - FR ( *) ) FR ( *) A

(3.28)
206

Chapter 3: Liquidity Measurement

Further substitutions are possible for normally distributed offers:358


* -1 * -1 E ( > *) (1 - FR (*) ) = 1 - +

(3.29)

* -1 * -1 2 E( 2 > *) (1 - FR (*)) = ( * +1) + + 1 1 -

(3.30)

The new term A appearing in all above equations requires additional explanations.
The volatility of the market uncertainty factor A refers to the uncertainty about
the market change until the property is sold. As assumed, the searcher expects the
market to follow a deterministic trend until the next potential buyer arrives, but
she is not sure whether some unexpected events will not cause unforeseen changes in
the offer distribution. Hence, higher A means that a significant deviation from the
trend is more probable. In the practical application, finding an adequate proxy for
this variable may be difficult. Using the variance of prices observed at intervals
corresponding with the base interval of the model (i.e., the interval to which the
trend, the discounting factor, the offer arrival rate etc. refer to) is a possible
solution. It seems also plausible to differentiate between the "typical" variance
and the "worst case" variance. The latter approach would be especially worth
considering in the case of an unexpected liquidation, when potential liquidity
problems occur in times of unexpected market shocks. For liquidity analysis, it is
especially interesting how the variance of sale receipts depends on the search
strategy and, in particular, on the reservation price. Consider setting a very low
reservation price first. The seller is then ready to accept any offer independent
of its value. Intuitively one can expect the volatility of receipts to be
approximately equal to the volatility of offers. Setting an infinitely low * in the
formula (3.28) results in the receipts' variance of: V ( * - )

2 = 2 ( X 2 + 2 Z 2 ) + 2 (Y2 - X1 Y1 ) + 2 Z 2 - Y12 + 2 Z 2 + X 2 -
X1 A A

(3.31)

Note that this is in fact the original relative variance of offers corrected for
the uncertainty about the arrival time of the first offer, for the possible market
change up to

358

See Appendix A.4.1and A.4.2 for the full derivation.


3.3 Measures of Liquidity Risk

207

this point, and for rental revenues achieved. For relatively high offer
frequencies, low discounting factors, and relatively stable markets V() approaches
. On the other hand, the receipts' variance should approach zero for very high
reservation prices. In this case, the sale becomes practically impossible and the
investor can only expect an endless flow of rental revenues. The outcome of the
search is then practically predefined and barely varying.359 The extreme values of
the reservation price describe investors willing to sell an asset at any price or
not willing to sell it at all. Yet, from the practical point of view, intermediate
values of * are most interesting. Especially relevant is the question whether a
unique reservation price exists for which the variance is minimal. Unfortunately,
an analytic proof of this property is not possible. However, results of multiple
simulations for parameter values, which seemed to be realistic for real estate
markets, allow some conclusions concerning this issue. Firstly, in most cases a
clear local minimum existed; secondly, a clear local maximum followed each time.
The typical pattern is depicted in Figure 3-2. It is assumed to be valid in
"normal" market situations, though the lack of a formal proof is disturbing at this
point. However, since this property is not really crucial for further reasoning,
the issue is not further followed.

359

Formally, the limit of V() for * is positive; this is, however, due to the
assumption that the rent is payable at the arrivals of offers. The positive
variance results only from the uncertainty about the timing of the rental income.
208
0,4 0,35 0,3

Chapter 3: Liquidity Measurement

Receipts' Volatility

0,25 0,2 0,15 0,1 0,05 0 0,0 0,2 0,4 0,6 0,8 1,0 1,2 1,4 1,6 1,8 2,0

Reservation Price

Figure 3-2: Volatility of net sale receipts as a function of the reservation


price360

Note that the volatility of relative net sale receipts corresponds with the
approach proposed by Garbade/Silber (1979). The "variance of the difference between
the equilibrium value of an asset at the time a market participant decides to trade
and the transaction price ultimately realized" (p. 577) formulated in terms of the
search model is the variance of the difference between the receipts from sale and
the average valuation of the asset at the beginning of the search. Since the latter
one always equals one in the relative approach, Garbade's and Silber's liquidity
measure defined in this context is simply: V(1) = V(). There are several reasons
why the variance of receipts is an appealing measure of liquidity risk. The first
one is the popularity of this statistical mass of dispersion in many fields of
finance. Researchers and practitioners are used to using it, what surely helps to
avoid misinterpretations in many cases. This advantage should not be
underestimated, especially if practical application is considered. The second
reason for using volatility is the possibility of its analytical computation, which
is not easy, if at all
360

Net receipts' volatility has been computed for search model in the relative
approach with normally distributed offers. Following parameter values have been
assumed: offer dispersion = 15%; market volatility = 5% p.a.; interest rate = 15%
p.a.; income return = 5%; offer frequency = 52 per year (or 1 per week).
3.3 Measures of Liquidity Risk

209

possible, for many other measures (see following sections). The formula provided in
this section is quicker and handier than numerical or simulation-based
approximations. Finally, problems concerning the distribution of random market
changes (deviations from the trend) arising from the assumption of the expected
value of the market uncertainty parameter being equal to 1 (see the discussion in
section 2.3.1.5) are avoided since no assumption about the functional form of the
distribution of A is necessary. The standard deviation or variance of this
parameter is all that is required. 3.3.3. Asymmetric Measures

Volatility, and symmetric risk measures in general, are based on the notion of risk
regarded as the possibility of any deviation from the assumed target, in
particular, from the expected value of the goal variable. However, investors are
typically concerned only about the possibility of underperforming the target.361
They usually prefer to avoid achieving low returns or suffering high losses, but
the possibility of performing better than expected, i.e., realizing extraordinarily
high returns or revenues, can be hardly viewed as disadvantageous. As long as the
goal variable is symmetrically distributed, the risk of performing worse and the
chance of performing better than expected are equal. Volatility is than
proportional to the downside risk. However, it under- or overestimates the true
risk under a skewed distribution (see Figure 3-3). Application of downside risk
measures is advised in such cases.

361

See Sortino/van der Meer (1991).


210
a) b)

Chapter 3: Liquidity Measurement

Figure 3-3: Total variability and downside risk under a right-skewed (a) and a
left-skewed (b) distribution of the goal variable.362

The estimations of the distribution of net sale receipts obtained using a Monte
Carlo Simulation based on the real estate search model give rise to the
apprehension that its asymmetry is a rule rather than an exception.363 The grade of
skewness depends on the relation between the income return, the trend rate, and the
discount rate. A roughly symmetrical distribution of receipts results when the
discount rate is equal to the sum of the income return and the trend rate; higher
discount rates lead to right-skewed distributions, and lower discount rates lead to
left-skewed distributions. Thus, under certain conditions, volatility may be
misleading when the investor is downside risk oriented. This justifies the
consideration of downside risk measures for the purpose of liquidity risk
measurement. Apart from the integration of liquidity risks in the Value at Risk,
there have been, to my best knowledge, no attempts to measure liquidity risk in the
downside-risk framework so far.

3.3.3.1. Default Probability


Default probability (DP) in credit business is defined as the probability that a
debtor will not be able (or willing) to repay outstanding debt with interest as
scheduled. In investment risk management, it describes the probability that the
return from a certain investment falls below some critical level.364 Using the same
logic, one can define de362 363 364

See Morawski/Rehkugler (2006), p. 13. See section 2.3.4. See Steiner/Bruns (2002),
pp.64-65. Most distinctive application of the default probability in investment
risk and portfolio analysis is in safety-first models. See Rudolf (1994), Breuer et
al. (1999), pp. 336-372, or Elton et al. (2003), pp. 235-241, for a review.
3.3 Measures of Liquidity Risk

211

fault probability with respect to liquidity risk. It corresponds with the


probability that the achieved net sale receipts are below some minimum value.
Within the search framework, a default in the above sense occurs when a sale price
is accepted that after adding up all search costs and revenues and after
discounting leads to a sale value lower than the minimum required one. Thus, for
each period of search (i), a minimum price exists that needs to be achieved in
order to avoid a default; it is denoted as PM,i. A default is not possible as long
as the minimum price is smaller than the reservation price any acceptable price
guarantees total net receipts higher than the minimum level in this case. Also, a
default can occur in a period i only if the asset has not been sold until then.
Thus, the probability of default in terms of liquidity risk can be expressed as
follows: DP = Pr(G < G M ) = Pr(Pi < PM,i Pi > p *) Pr(Pi > p*) Pr(Pj < p*)
i j=1 i -1

(3.32)

For the real estate search model from section 2.3, the default probability is
defined analogously. However, since the model is formulated in terms of relative
values, also the minimum (relative) net receipts and the minimum price are related
to the average market valuation. DP = Pr( < M ) = Pr( i < M,i i > *) Pr( i >
*) Pr( j < *)
i j=1 i -1

(3.33)

M,i in this formula is defined as follows:


i ~ ~ ~ -( - )Tj M = M ,i (1 + A Ti ) e -(- )Ti + Tj e j=1

M ,i =

M - Tj e
j=1

~ -( - )Tj

(3.34)

~ ~ (1 + A Ti ) e -( -)Ti

Unfortunately, no further simplification of the DP-formula is possible, at least


not without highly simplifying distributional assumptions. This is a serious
difficulty in the practical application of DP common to all downside risk measures.
A numerical approximation should be possible in certain cases. A more general
alternative includes
212

Chapter 3: Liquidity Measurement

a MCS conducted according to the scheme presented in section 2.3.4. Applying it


allows assessing the distribution of sale receipts; the fraction of scenarios that
led to values below the minimum receipts gives the approximated DP value. However,
a potentially serious problem with computations based on numerical or Monte Carlo
methods is the required knowledge of the p.d.f. of the uncertainty factor A. On the
one hand, normal distribution is inconsistent with the hypothesis of a random walk
in returns and would lead to a negative drift in prices in the long run. On the
other hand, log-normal distribution is compatible with the classical capital market
theories but causes problems with the myopic property of the search model.
Following the argumentation in section 2.3.1.5, normal distribution of A is assumed
wherever necessary. For relatively low volatilities of A and/or relatively short
durations of search, the aberration caused by this assumption should be negligible.
This is also apparent from Figure 3-4.

1,2

Default probability

0,8

0,6

0,4

0,2

Logrnomally distributed A Nomally distributed A

0 0,00 0,07 0,15 0,22 0,29 0,37 0,44 0,51 0,59 0,66 0,73 0,81 0,88 0,95 1,03 1,10
1,17 1,25 1,32 1,39 1,47 1,54 1,61 1,69 1,76 1,83 1,91 1,98

Reservation price

Figure 3-4: Default probability as a function of the reservation price365

365

Default probabilities were computed for the relative search model with normally
distributed offers. Following parameter values were assumed: minimum receipts = 1;
offer dispersion = 15%; market volatility = 5% p.a.; interest rate = 15% p.a.;
income return = 5%; offer frequency = 52 per year (or 1 per week). The simulation
was conducted with 1000 runs for each reservation price.
3.3 Measures of Liquidity Risk

213

Another critical issue in the practical application of the default probability is


the choice of the minimum search value or the minimum required (relative) net sale
receipts. Since it is a subjective parameter determined by what the investor
considers to be a sufficient revenue, the concrete choice depends on her personal
attitude; however, one can attempt to define economically plausible values. The
most straightforward approach is to derive it from the minimum return required for
the analysed asset during the planned holding period. If the asset was acquired at
a price P0, and the minimum return is RM, the minimum absolute net receipts would
be GM = P0(1+RM). Correspondingly, the minimum relative net receipts would be M =
P0(1+RM)/P1, where P1 is the asset's average price at the end of the time horizon.
Reasonable values of RM are: zero (nominal wealth preservation), inflation rate
(real wealth preservation), risk free, or risk adjusted interest rate.366 Another
possibility is to use the average market valuation. It corresponds with setting M =
1 when DP is computed on the basis of the real estate search model. Investor's goal
implied by this approach is to perform at least as well as an average investor
would. If the average valuation is interpreted as the "would be" liquid price
(quasi-market price), one can also interpret this approach as the endeavor to
perform at least as well as it would be possible if the asset was perfectly liquid.
The complex form of the default probability formula makes it difficult to analyze
it analytically. However, some of its properties can be guessed intuitively.
Setting the reservation price very low (infinitely low) has the effect that the
first incoming offer is accepted. The probability of a default is then simply the
probability that the minimum price is not reached with the first offer. If the
observation and opportunity costs are low, and the market is relatively stable, it
should not diverge far from the c.d.f. value of the offer distribution for the
minimum receipts' level (i.e., F(GM) or FR(M)). Setting an infinitely high
reservation price results in an infinite search, and the receipts are equal to the
present value of infinitely generated observation costs and revenues. If the latter
value is lower than GM or M, a default is sure and PD=1; otherwise, it will never
occur and PD=0.367 However, if the reservation price is finite, no straightforward
general conclusions are possible. The outcome depends largely on the level of
market
366

367

On the choice of a return benchmark for downside-risk measures see Schmidt-von


Rhein (1996), p. 427-431. Note that the postulated default probability of 1 for an
infinitely high reservation price and low rental revenues is in conflict with the
formal definition of default in equation (3.33). A default in this equation can
occur only when a sale is accomplished. Since this never happens when the
reservation price is infinite, the equation provides a misleading result in this
case.
214

Chapter 3: Liquidity Measurement

uncertainty. With a relatively stable distribution of offers, one could expect a


decreasing DP for low reservation prices as very low sale prices are excluded, and
an increasing DP for high reservation prices as the probability of a successful
sale diminishes. This would suggest the existence of a local minimum. However,
higher reservation prices also lead to longer search durations increasing the
potential magnitude of market changes. It is not clear which of these effects, the
falling probability of sale or the potentially large negative deviations from the
trend, outweighs, especially if highly volatile markets are considered. Above
considerations are based on intuition rather than on formal analysis. To support
them, several simulations assessing the DP in representative real estate scenarios
have been conducted. An example of the typical plot of the default probability as a
function of the (relative) reservation price, with the average market valuation
used as the minimum receipts' level, is presented in Figure 3-4. The results are in
line with expectations: a DP of ca. 50% results for very low values of *, and it
approaches one for large *. A unique minimum has been observed in most cases.
However, these results can only serve as an indicator and are no proofs of general
properties of the PDfunction. Additionally, due to technical limitations of
simulation techniques in probability tails, they should be interpreted with caution
for very high and very low reservation prices.

3.3.3.2. Semivolatility and Lower Partial Moments


Default probability provides information about the chances of missing the
liquidation target. However, used as a liquidity risk measure, it only
differentiates between sale receipts above and under the minimum level the extent
to which the target is missed remains disregarded. In effect, two investments would
be judged as having the same liquidity risk as soon as the DP values were equal,
even if one of them would lead to substantially higher shortfalls below M than the
other one. Such conclusion would be clearly inconsistent with investors' perception
of risk. Not only the mere fact of not reaching the minimum required target
matters, but also by how much it has not been reached. Hence, it seems more
appropriate to use measurement approaches that include the distance between the
realized and the minimum receipts. Semivolatility and lower partial moments, of
which semivolatility is a special case, meet this requirement.
3.3 Measures of Liquidity Risk

215

Semivolatility is defined in analogy to volatility; the only difference is the fact


that only negative deviations from the mean are regarded. Appling it to the
relative net sale receipts yields the following formula:368

SV() = E (max(0; E () - ) 2 )

(3.35)

For symmetrically distributed receipts, semivolatility equals volatility divided by


the square of 2, i.e., SV() = V()/2. Since the relation between the two measures is
then proportional, they yield identical assessments of the relative liquidity risk
for different assets. However, this does not hold for an asymmetric (skewed)
distribution of receipts. As already noted, semivolatility can be considered as a
special case of the lower partial moment (LPM) developed by Bawa und Fishburn.369
LPM constitutes a generalization of the downside risk concept and can be defined
for relative sale receipts as follows:370
LPM(T , n) =
T

(T - )

f() d

(3.36)

T denotes the target or the minimum net receipts from sale. It can be equal to the
expected net receipts, as it is in the case of semivolatility, but any other fixed
value can also be used. The choice of this parameter follows the same logic as the
choice of M in the case of default probability. The parameter n defines investor's
risk aversion. For n = 0, one receives the default probability discussed in the
former section. With n = 1 and the target equal to the expected receipts, LPM
becomes the mean downside deviation or the expected loss; and with n = 2, it is the
semivariance or, when a root is extracted, semivolatility.371 The values of n do
not, however, need to be integers. This allows a very precise adjustment of LPM to
the individual attitude of a specific investor. For high n values relatively more
weight is assigned to higher deviations from the target this characterizes a
strongly risk averse investor who tolerates none or only slight shortfalls. On the
other hand, low values of n characterize an aggressive inves368

369 370 371

See Harlow (1991), Sortino/van der Meer (1991), Schmidt-von Rhein (1996), pp. 445
ff., Fss (2004), pp. 410 ff., or Morawski/Rehkugler (2006). See Bawa (1975) and
Fishburn (1977). For a review of the concept see also Nawrocki (1999) See Harlow
(1991), pp. 30 and 40. See Nawrocki (1999), p. 14.
216

Chapter 3: Liquidity Measurement

tor. Her prime objective is not to miss the target; however, if the target is
missed, she may even prefer higher losses to lower ones (for n < 0). Such attitude
may be described as "conditional risk seeking" opposed to "normal" risk
aversion.372 In addition to the compliance with the more natural, downside-oriented
attitude to risk, an important advantage of LPM measures is their compatibility
with the utility theory, especially with many of Neumann-Morgenstern utility
functions.373 As Fishburn (1977) shows, they are also equivalent with the concept
of stochastic dominance.374 The already mentioned ease of adjustment to individual
requirements of investors is a further reason to use LPM for liquidity risk
measurement.375 However, the relative complexity of computations needs to be
outweighed against these advantages. The problems are especially severe if LPM (or
semivolatility) is to be computed not for historical liquidation data but on the
basis of a search model. No analytical formula can be derived then, so that the use
of simulations is inevitable.

3.3.3.3. Value at Risk


A practically relevant risk measure, closely related to Default Probability, is
Value at Risk (VaR). It stems from credit risk management, but has become
widespread also in other business areas.376 The logic behind this measure is to
disclose "the worst expected loss over a given time interval under normal market
conditions at a given confidence level"377. In other words, it answers the
question: how much can I loose with a given probability over a given time horizon?
Thus, instead of the probability of missing a target, the minimum target with a
given probability of missing it is determined. VaR can be defined either as the
difference between today's (V0) and minimum future value of an asset (absolute VaR)
or as the difference between its future expected and future minimum value (relative
VaR):378

372 373 374 375

376 377 378

See Nawrocki (1999), pp. 14-15, and Fishburn (1977), p. 119. See Nawrocki (1999),
p. 16 and Fishburn (1977), pp. 120 ff. See Nawrocki (1999), p. 15, and Fishburn
(1977), pp. 122 ff. A method of adjustment of the LPM to investors' preferences is
presented by Nawrocki/Staples (1989). See Jorion (2001) for an extensive review of
VaR measurement. Jorion (2001), p. xxii. See Jorion (2001), p. 109.
3.3 Measures of Liquidity Risk

217 (3.37)

VaR absolute = V0 - V * VaR relative = E(V) - V *

There have been several attempts in the literature to allow for illiquidity in the
VaR framework. Most of them consider the problem in terms of liquidation costs in
organized stock markets and concentrate on the exogenous liquidity risk only. This
course of research was initiated by Jarrow/Subramanian (1997) who address the
optimal liquidation of stocks in a market on which trading large quantities affects
prices.379 The investor (seller) can chose a liquidation strategy defined by
quantities sold at multiple transactions each of which affects the market price.
Her choice determines the total discount resulting from the sum of discounts at
single trades as well as execution lags. Basing on a continuous time model with
prices following geometric Brownian motion, the authors propose a modification to
the traditional market risk VaR. Analogous approaches to the adjustment of VaR for
liquidity risk are applied by Almgren/Chriss (1998, 2000/2001) and Dubil (2002,
2003a, 2003b) who additionally divide the market impact of liquidation in the
temporary and the permanent component.380 While the above researchers consider only
endogenous liquidity risk induced by the execution of a large transaction, Bangia
et al. (1999) concentrate on exogenous liquidity risk arising from the fact that
the bid-ask spread is subject to fluctuations. They use the cost of liquidity
defined as the maximal spread at a certain confidence interval to adjust the
standard market risk VaR. Several authors extend the model of Bangia et al. to
include both exogenous and endogenous liquidity risk in VaR, among them Le Saout
(2002), Franois-Heude/Van Wynendaele (2001), and Angelidis/Benos (2005). VaR
corrections in the above mentioned papers are based on the fact that investors are
concerned not only about value deterioration due to a general market decline but
also due to unusually high liquidity costs. Since the illiquidity discount is
assumed to be normally distributed (it is the consequence of the random walk in
returns), Liquidity VaR (LVaR) can be computed for a given liquidation strategy as
the upper bound of the discount's confidence interval:381 LVaR=E(discount) +
S(discount)
379 380 381

(3.38)

See also Subramanian/Jarrow (2001). See also Moorthy (2003), pp. 32 ff. The
definition of LVaR can also refer to the liquidation value instead of the
liquidation cost as it does in Dubil (2002, 2003a, 2003b); the results are
analogous.
218

Chapter 3: Liquidity Measurement

where the risk aversion parameter corresponds with a certain confidence level x%
satisfying the following condition:382 Pr(discount < LVaR())=x% (3.39)

An interesting feature of this approach is the possibility of interpreting the LVaR


in terms of a utility function. This aspect is discussed more closely in section
3.4.2. Several other researchers deal with liquidity risk in the VaR context.383
Literarily none, however, (to my best knowledge) go beyond public markets.
Consequently, none of the existing models can be practically applied when no
unambiguous and publicly known market price exists. This drawback can be solved by
using a search model to derive Liquidity VaR for private markets; in particular, an
operational LVaR measure for real estate investments can be computed using the real
estate search model. It is then the difference between the minimum liquidation
value realized with a given probability and the reference value. The first
component corresponds with the minimum net sale receipts at a given confidence
level and can be determined by reversing the default probability formula (3.32) or
(3.33). Similarly as for the default probability, no analytical computation will be
possible in most cases, but a numerical approximation or estimation on the basis of
a MCS should be feasible. The choice of the reference value is less obvious.
Asset's current market value (absolute VaR) or its expected future value (relative
VaR) is used in the original VaR concept (see equation (3.37)); however, these two
approaches lead to entirely different results when applied in the search framework.
Using assets' current market values in LVaR computations is obviously not directly
possible in private markets; the expected (current) offer or the expected net
receipts from an immediate liquidation (0) could be applied instead. This leads to
the following definition of the absolute LVaR: LVaRabsolute = 0 Gmin, x% (3.40)

382

383

For banks, the implicit risk aversion in the context of VaR arises from the
required confidence intervals set by supervision authorities usually at ca. 99-
99.5%. See Berkowitz (2000), Cherubini/Della Lunga (2001), or Giot/Gramming (2002);
on the Liquidity VaR see also Jorion (2001), pp. 339-357.
3.3 Measures of Liquidity Risk

219

The minimum receipts from sale at the end of the investment horizon achieved with
the confidence of x% (i.e., Gmin, x%) correspond with the receipts defined in the
expression (3.32). Since 0 is an absolute value, this approach makes only sense
when the absolute version of the search model is used. The minimum liquidation
value is then defined as an absolute value and depends not only on the confidence
level but also on the market state at the beginning of the search process, in
particular, on the level (mean) of offers at this time (t).384 As soon as future
liquidation is considered, t refers to the future average valuation of the asset
and is uncertain. In consequence, also Gmin is uncertain and subject to possible
market changes during the holding period. This means that the absolute LVaR
encompasses liquidity risk arising from the necessity to search for a buyer as well
as market risk arising from possible changes of asset's valuation among market
participants. Ignoring the latter aspect, i.e. assuming some deterministic state of
the market at the end of the investment horizon (e.g., the expected value of t),
could yield a higher LVaR value and, thus, indicate lower liquidity risk for assets
that are expected to yield higher returns over the investment horizon. On the other
hand, assuming an uncertain t leads to a VaR measure encompassing total investment
risk and not only liquidity risk. Asset's future expected value seems to be more
appropriate reference for the search model based LVaR. Since both values in the
formula of the relative VaR (3.37) refer to the same moment in the future (i.e.,
the beginning of the liquidation process) in this case, there is no need to regard
the market risk component. A practical benefit of this approach is the possibility
of applying the relative version of the search model. The minimum sale receipts at
a given confidence level x% (min,x%) are then expressed as a fraction of the
(future) average valuation by potential buyers (t), and the asset's expected
future value can be interpreted as the expected net receipts under the optimal
liquidation strategy. The latter one results in the real estate search model from
optimizing the equation (2.38) with respect to *. Thus, the relative LVaR is
defined as:385 LVaR relative = max[ E( *)] - min ,x%
*
384

(3.41)

385

Of course, also the reservation price and other model parameters determine the
minimum liquidation value; they are omitted for better tractability. Maximization
of expected net receipts is assumed in the formula (3.41). Note, however, that also
other notions of optimality are possible here, e.g., risk minimizing.
220

Chapter 3: Liquidity Measurement

This version of the measure answers the question: "how far, relative to the average
market valuation and at a given confidence level, can the result of the liquidation
lie below the expected one when the optimal search strategy is applied". Note that
due to the relative definition of prices, the relative LVaR is independent of the
average price level and is valid as long as other parameters of the search model
(especially the divergence of opinions, market trend, and offer arrival rate)
remain unchanged. There is therefore no need to precisely determine the time
horizon, and the relative LVaR can be applied to both the expected and the
unexpected liquidation. Another interesting alternative for the reference value in
the LVaR formula is the asset's future average valuation. In the real estate search
model, it corresponds with the expected relative value of offers, which is by
definition equal to one. Thus, the market level based LVaR (LVaRM) equals: LVaRM =
1 min, x% (3.42)

Assuming that the absolute average valuation among potential buyers corresponds
with the hypothetical market value of the property if it was perfectly liquid (see
discussion in section 2.4) allows defining LVaRM as the maximal possible loss
arising from the fact that the asset is illiquid.

3.4.

Alternative Measurement Approaches

Each of the hitherto discussed liquidity measurement concepts concentrated on one


facet of the problem only. In the case of the traditional measures, it was the
(expected) market liquidity and the cost of its lack. The time- and probability-
related measures focused on the duration and the probability of successful
liquidation of an asset, and risk measures regarded the uncertainty about the
outcome of the liquidation. Considering the substantial differences between these
approaches, it seems rather impossible to capture the full scope of liquidity
within one figure. Nevertheless, in many cases a measure combining several various
aspects would be desirable. This refers especially to the two main dimensions of
asset liquidity: marketability and liquidity risk. Two possible approaches to this
task are discussed in this section. The first one borrows from the concepts of
performance measures, which are very popular in the analysis of stocks. Although to
my best knowledge no attempt in this direction has been made so far, it seems
possible to derive several "liquidity performance measures" on the basis
3.4 Alternative Measurement Approaches

221

of the search framework. Another possibility builds on the concept of utility. The
few existing approaches following this idea are presented and discussed in the
light of the search theory. Since all measures addressed in this section assume
individual search for a trading partner, they refer mainly to asset liquidity.
3.4.1. Liquidity Performance Measures

The most popular approach to combine various characteristics of investment


alternatives is the computation of performance measures.386 The goal is usually to
present the return position of an investor after correcting for investment risk. In
general, the construction of performance ratios follows the following principle:387
Performance = (Expected return Benchmark return)/Risk (3.43)

An often used interpretation is the unit price of risk, i.e., the additional return
achieved for each unit of risk that is accepted with the investment. Using this
general principle, a number of different performance measures can be defined
depending on the notions of return and risk and on the type of the benchmark. An
analogous approach can be applied to liquidity. The analogy between the expected
liquidation value and the expected return as well as between liquidity risk and
investment or market risk, which is discussed in more detail in Chapter 4, is very
useful at this point. Thus, one could ask about investor`s reward for accepting
liquidity risk associated with a certain asset. The natural benchmark for measuring
the reward is the case of a perfectly liquid asset for which liquidity risk is
zero. A liquidity performance measure in this sense could be interpreted as the
additional expected liquidation value arising from liquidating an illiquid asset
instead of a liquid one computed per unit of liquidity risk involved in such
liquidation or, simply, as the unit reward for assuming liquidity risk. The most
straightforward way to implement the above idea is by defining the expected
liquidation value and liquidity risk as the expected net sale receipts and the
volatility of sale receipts, respectively. Both expressions can be computed on the
basis of the real estate search model. The benchmark i.e., the liquidation value
of a perfectly liq-

386

387

See Levy/Sarnat (1984), pp. 515-559, or Wittrock (1995), part C, for an extensive
review of performance measures. See Steiner/Bruns (2002), p. 597.
222

Chapter 3: Liquidity Measurement

uid asset is always equal to 1 in the relative search model. The resulting
Liquidity Risk Reward (LRR) is then defined as follows:388

LRR(*) =

E( *) - 1 S( *)

(3.44)

Since both expected net receipts and receipts' volatility are functions of the
reservation price, also LRR depends on the reservation price. Thus, the liquidity-
performance of an illiquid asset can vary depending on the liquidation strategy of
the seller. In order to use LRR for comparing various illiquid assets or markets,
it seems reasonable to consider only those reservations prices which lead to the
maximal performance. This reasoning leads to the following asset-specific and
liquidation strategy-independent LRR*:

LRR* = max[LRR(*)]
*

(3.45)

An important property of this measure is its consistence with the optimal search
strategy in the case of simultaneous liquidation of liquid and illiquid assets. As
discussed in section 4.3.2, the optimal reservation price is then independent of
investor's preferences, and consequently, LRR* becomes (at least to some extent) an
objective measure of liquidity. Basing on the above idea, further liquidity
performance measures can be developed by applying different measures of liquidation
value (marketability) and uncertainty. In particular, different liquidity risk
measured discussed in section 3.3 can be applied, among them especially the
asymmetric measures. Furthermore, Liquidity Beta (LBeta) defined in section 4.3.3
can be used for this purpose. However, one must note that its interpretation does
not quite correspond with that of the market Beta. L-Beta refers always to a
specific portfolio containing illiquid assets and is different for each investor.
As such, it is not suitable for comparisons of assets or markets and allows only
determining the relative liquidity performance of an asset within a given portfo388

Note that there seems to be some analogy between Liquidity Risk Reward and Sharpe
Ratio. The latter measure is defined as the relation of the expected excess return
of an asset over the risk-free rate to the asset's return volatility (see Sharpe,
1966, as well as Sharpe/Alexander, 1990, pp. 750752, Sharpe (1994), or Elton et
al., 2003, pp. 626-628). By substituting liquidation receipts for returns as the
central variable and considering a perfectly liquid asset to be liquidity risk-
free, the LRR ratio results.
3.4 Alternative Measurement Approaches

223

lio. Hence, also liquidity performance measurement based on L-Beta would be valid
only within a certain portfolio. Before concluding the presentation of the
liquidity performance measures, the issue of their correct interpretation needs to
be highlighted. It is important to note that these measures refer explicitly to
assets and not to markets. Thus, they are based on individual optimization of
reservation prices and take higher values for assets which allow individual
investors to achieve higher sale receipts. In other words, given a constant level
of liquidity risk, an asset that sells at a higher premium to its average valuation
when marketed under the optimal selling strategy is considered to be more liquid.
In contrast, traditional liquidity measures refer to the (expected) market
liquidity, i.e., to the average ability to buy or sell assets. In consequence, both
groups of measures may under certain circumstances yield inconsistent results. This
is best visible in the comparison of the Liquidity Risk Reward with the bid-ask
spread. While higher expected receipts increase (ceteris paribus) the LRR ratio,
they lead to higher bids, higher trading costs, and lower market liquidity with
respect to the spread. This difference is due to the implicit assumption about the
investor's ability to act strategically, which lies behind the concepts of market
and asset liquidity. While the Implicit Spread, QSD, and other related measures
assume that the seller is passive, i.e., she accepts the sale price offered by the
dealer (bid) or by the market (average valuation), the performance measures
presented in this section allow for an active search for a buyer. In effect, the
seller is never passive even under a very high time pressure, she attempts to
maximize the present value of sale receipts. The increase in the expected outcome
is, however, evaluated in relation to the involved uncertainty. Thus, in contrast
to the traditional measures, performance measures address an "active" investor
willing to measure the subjective liquidity of her assets rather than the objective
liquidity of markets to which these assets belong. As such, they seem especially
appropriate for assessing liquidity of privately traded investments. 3.4.2.
Utility-Based Measurement

Since the characteristics of sale receipts depend on the reservation price and as
such can be controlled to some extent by the seller, subjective liquidity of an
asset is also affected by investor's preferences. It is therefore straightforward
to use the personal utility function to quantify the grade of liquidity. Few
researchers followed this approach; among them most distinguishable are papers by
Mok (2002a, b). Also the
224

Chapter 3: Liquidity Measurement

course of research concerning the interpretation of Liquidity-VaR in terms of


utility can be associated with utility based liquidity measurement. In both cases,
the basic idea is to measure liquidity with the highest utility level achievable by
optimizing the liquidation strategy. Mok's starting point is a simple search model
with discounting similar to the one by Karlin (see section 2.2.4). Additionally,
Mok (2002b) adds the possibility of multiple offers per period interpreting this
parameter as market thickness. She considers two sale settings, a finite horizon
with 2 or i periods and an infinite horizon; for each of them the expected value
and the variance of net liquidation receipts is derived. Both statistics are
functions of the reservation price, which defines the search strategy. Mok analyzes
the effects of changes in model parameters on the outcome of the sale process
demonstrating, e.g., that searching can be more attractive in thicker markets. Up
to this point, the analysis does not significantly differ from the standard search
analysis presented in Chapter 2. Conceptually new is, however, the introduction of
utility from liquidation, which depends on both the expected sale receipts and the
standard deviation of sale receipts.

U(p*) = E(G p *) - S(G p *)


with: - risk aversion parameter

(3.46)

The optimal search strategy in this setting is the one that maximizes the utility
of the seller. Obviously, it is different form the strategy maximizing the expected
receipts considered usually in the literature and depends on the grade of risk
aversion.389 Conceptually related to the Mok's approach is the utility
interpretation of Liquidity Value at Risk (LVaR).390 Given normal distribution of
liquidity discounts (or in fact any symmetric distribution), the upper bound of the
confidence interval for the maximum liquidation cost can be presented as the mean
less the standard deviation scaled with a parameter , which corresponds with the
confidence level x%.391 Defining the

389

390 391

In fact, Mok's concept is closely related to the main idea of the Modern Portfolio
Theory discussed more closely in the following Chapter it requires the assumption
that either investor's preferences are quadratic with respect to sale receipts or
that the distribution of receipts is normal. See especially section 4.1.4. See
Almgren/Chriss (1998, 2000/2001), Dubil (2002, 2003a, 2003b), Moorthy (2003), p.
33. See also expression (3.38).
3.4 Alternative Measurement Approaches

225

liquidation discount as asset's non-random fair value (FV) less the random realized
liquidation value yields:
LVaR = E(FV - LV) + S(FV - LV) = FV - E(LV) - S (LV)

(3.47)

It results in the minimal value at an x% confidence interval of:


FV - LVaR = E(LV) + S (LV)

(3.48)

Note that this notion of LVaR is equivalent to the quadratic utility function
similar to the one utilized by Mok. Since both the discount and the liquidation
value are conditional on the liquidation strategy, they can be influenced by the
investor. Minimizing LVaR and, thus, maximizing asset's minimal liquidation value
corresponds in this case with utility maximization. Basing on the concept of
liquidation utility, Mok defines the liquidity cost as the decrease in utility due
to a shorter sale horizon. It is the difference between the utility resulting from
selling quickly within i periods (Ui) and the utility resulting from selling ~ ~
optimally within the time horizon T ( U ): T
~ ~ Liq t ,T = U i - U T

(3.49)

~ Typical choices of i and T would be 1 and , respectively; U1 is then the utility


of an immediate sale, and U is the maximal achievable utility with an unlimited
search horizon.

Mok's liquidity measure is, in fact, analogical to the Quick Sale Discount from
section 3.1.2.2 applied on the level of utility. An investor forced to sell quickly
has to give up some of the utility she could gain when she searched optimally. This
loss comes, on the one hand, from the possibly reduced expected net sale receipts
and, on the other hand, from the possibly increased receipts' volatility. In
illiquid markets, a quick sale would result in larger discounts in overall utility;
in perfectly liquid markets, search is not optimal anyway so Mok's measure would be
zero. As indicated by Dubil (2002, p. 72), introduction of utility to liquidity
measurement opens nearly unlimited possibilities for designing new measures. The
form of the utility function does not need to be limited to the quadratic one; in
particular, one could
226

Chapter 3: Liquidity Measurement

pick HARA (Hyperbolic Absolute Risk Aversion) or any other widely acknowledged type
of preferences.392 Also the set of utility-relevant variables can be extended;
e.g., the skewness of sale receipts' distribution could be included. Further
possibilities open when traditional liquidity measures are redefined in terms of
utility, e.g., as a "utility spread" the sum of utility losses from
simultaneously purchasing and selling an illiquid asset. Properties of such
measures depend on the applied utility measurement approach, which should be chosen
according to the preferences of the decision maker. They are therefore always
subjective measures, tailor-made for a specific investor. This may be a serious
limitation for the practical application when the characteristics of the investor
are unknown. Introduction of utility is one of the crucial issues in the
construction of rational approaches to liquidity management. In particular, it
plays a central role in most asset and portfolio selection models including the
Modern Portfolio Theory. The standard parametric approach to portfolio
optimization, the so called mean-variance approach, is based on the maximization of
investor's utility defined as a quadratic function of returns. When applied to
liquidation decisions or to portfolio selection with illiquid and privately traded
assets, it turns out to be closely related to Mok's approach presented above. This
issue is discussed in more detail in Chapter 4.

3.5.

Relations between the Measures

After a large variety of partially very different approaches to liquidity


measurement have been presented, the question arises to what extent they lead to
identical results and, thus, are exchangeable. Since they generally refer to the
same phenomenon, a certain linkage can be expected. Nevertheless, a closer look
reveals that it is by no means perfect, and that especially the measures of
liquidity risk clearly distinguish themselves from the other approaches. This
result is in line with the concept of two dimensions of liquidity discussed in
Chapter 1 in section 1.1.2. Analyzing relations between the measures also helps to
get a better idea of what is actually measured with different ratios. Probably best
researched are relations between the traditional liquidity measures referring to
public markets. They are also relatively easy to establish on the theoretical ba392

For a review of the utility measurement techniques see, e.g., Ingersoll (1987), pp.
39-40, as well as most handbooks on decision making.
3.5 Relations between the Measures

227

sis. Especially relevant in this context is the link between the bid-ask spread and
the quoted market depth (transaction size for which the spread is valid) the two
most popular measures. They are set by a market maker simultaneously and constitute
a trade-off: larger volumes are acceptable only at larger spreads.393 But there are
also easily explicable links to other measures. The spread between the bid and the
ask price depends, among others, on the cost of holding an open position until a
countertransaction occurs. Low trading activity, indicated by low volumes or
turnovers, gives fewer possibilities to close a position and leads to larger
spreads; dealers are less willing to accept large transactions unless they are
adequately compensated. On the other hand, higher spreads favor longer holding
periods and less frequent trading. Investors are then not eager to react to
relatively slight fluctuations of market prices even if they consider them to be
fundamentally unfounded. As a result, price reversals occur only slowly. Summing
up, spreads should be negatively correlated with market depth and positively
correlated with market resiliency; the correlation between depth and resiliency
measures should be positive. The above theoretical considerations have been often
tested empirically. The observed links were, however, often weaker than expected.
Lee et al. (1993) stated a highly significant negative dependence between quoted
spreads and quoted depths on the New York Stock Exchange (NYSE) using a
nonparametric test. Furthermore, a regression analysis yielded a strong positive
relation between normalized trading volumes and spreads and a strong negative
relation between volumes and quoted depths. Chordia et al. (2000) looked at the
correlations between quoted and effective spreads (absolute and proportional) and
quoted depths on the NYSE receiving values ranging from ca. 0.16 to 0.87 (see Table
3-1). The analysis of correlations between changes of different market breadth and
market depth measures computed by Chordia et al. (2001a and 2005) yielded similar
results. Using a ranking procedure Chalmers/Kadlec (1998) stated that "stocks with
high amortized spreads have both high effective spreads and high share turnover,
while stocks with low amortized spreads have both low effective spreads and low
share turnover."394 The cross-sectional correlation between the amortized and the
quoted spread remained, however, on the level of 0.54.395 Huang/Stoll (1996)
compared quoted and effective spreads with realized spreads receiving correla393
394 395

See Lee et al. (1993), pp. 49-51 Chalmers/Kadlec (1998), p. 167. See
Chalmers/Kadlec (1998), p. 167.
228

Chapter 3: Liquidity Measurement

tions between 0.7 and 0.8,396 and Brennan/Subrahmanyam (1996) stated literally no
correlation between their empirical price impact measure and the proportional
spread.397 Finally, Choi et al. (1998) tested the dependence between the quoted
spread and an extended version of Roll's implicit spread on an option market and
were able to explain over 80% of the variation of the latter one by the variation
of the former one.398
Table 3-1: Cross-sectional means of time series correlations between liquidity
measures for individual stocks on the YSE.399 QSPR PQSPR ESPR PESPR DEP 0.844 0.665
0.555 -0.396 0.549 0.699 -0.030 0.871 -0.228 -0.156 PQSPR ESPR PESPR

QSPR Quoted Spread; PQSPR Proportional Quoted Spread; ESPR Effective Spread;
PESPR Proportional Effective Spread; DEP Quoted Depth

Time on the market, probability of sale, and the proportional hazard ratio seem to
concentrate on a different aspect of liquidity than the traditional measures.
Liquidity is viewed from the perspective of a single transaction rather than from
the perspective of a whole market. The stress is also more on private rather than
public trading. Nevertheless, a relation to the traditional measures should exist.
It is best recognized in the link between the probability of sale and the trading
volume. The more probable the sale of an asset is, the more frequently transactions
should occur. In the ideal case, if trading activity is viewed in terms of a
Poisson or Bernoulli process, the average number of transactions per unit of time
should be equal to the reciprocal of the sale probability within this time
interval. Thus, the probability of sale multiplied with the market size (i.e., the
number of assets available for sale/purchase) should provide an estimate of the
trading volume. A link to the bid-ask spread can be established using formal market
models of dealers' and market makers' behavior, as demonstrated by Garman

396 397

398 399

See Huang/Stoll (1996), p. 345. See Brennan/Subrahmanyam (1996), p. 451. A


correlation of 0.03 between the price impact measure and the proportional spread
was found. See Choi et al. (1998), p. 227. Chordia et al. (2000), p. 8.
3.5 Relations between the Measures

229

(1976) or Amihud/Mendelson (1980).400 But also without a formal proof, it is


straightforward that sale probabilities and expected marketing times influence the
cost of market makers' operation and must be taken into account when setting
spreads. Furthermore, with more frequent trades and shorter marketing periods, also
reactions of markets to large transactions should be quicker; thus, resiliency
should increase. These considerations lead to the conclusion that a relation
between the probability-based and the traditional measures can be expected,
although, to my best knowledge, it has not been analyzed empirically so far.
Although these measures differ in their constructions, they seem to refer mainly to
the aspect of liquidity that corresponds with the expected outcome of liquidation,
i.e. to marketability. In the context of asset liquidity viewed as the relation
between the sale price and the sale time (see section 1.1.1.1), the traditional
measures seems to concentrate more on the price dimension, while the probability-
based measures, and in particular ToM, focus on the time dimension. As expected,
the connection between the traditional or probability-based measures and the
measures of liquidity risk is much less obvious. While the former concentrate on
expectations, the latter focus on the uncertainty about these expectations. At
first sight, there seems to be no apparent reason why they should influence each
other. For example, the level of market activity in highly risky markets (e.g.,
derivative markets) is not systematically different than in low-risk markets (e.g.,
money markets); it is not clear, why trading volumes should react differently to
liquidity risk. A closer look reveals, however, that some link may exist. It is
best visible in the analysis of the components of the bid-ask spread. In the ideal
case, competitive market makers should act risk neutrally. This means that,
ignoring the issue of asymmetric information, bid and ask prices should be based
only on expectations; fluctuations of the effectively realized prices (after
opportunity and holding costs) would offset each other due to the large scale of
market maker's operation reducing bankruptcy risk practically to zero. However, in
reality, full risk neutrality is usually not given. The reasons are the lack of
perfect competition between market makers on the one hand there is only a limited
number of market maker seats on most exchanges and the inability to extend the
scale of activity to a level at which fluctuations of the order flow can be fully
outbalanced. Thus,
400

In terms of the real estate search model, the link between the probability of sale
and the bid-ask spread can be identified by considering the dependence between the
implicit spread defined in section 3.1.2.1 and the frequency of offers, which is
one of the determinants of the probability of sale within a certain time interval.
For low levels of rental revenues, both the expected net receipts E() and the
expected net expenses E() should increase.
230

Chapter 3: Liquidity Measurement

the observed spreads may be affected by liquidity risk, especially when the market
is thin and there are fewer active dealers. In such cases, also other liquidity
measures could be affected in the same manner investors would need to account for
the additional source of uncertainty in their decisions to trade. In consequence,
there may be less turnover, and price reversals may occur more slowly. The extent
of this effect is, however, unclear and, to my best knowledge, no empirical
research on this issue exists. While the above discussed measures concentrate on
certain aspect of liquidity only, the alternative approaches are attempts to
combine various aspects. Therefore, by their nature, they should show connections
to all other measures. The extents and the directions of these links may, however,
vary very strongly. As already noted in section 3.4.1, the liquidity performance
measures may even lead to an opposite assessment of liquidity than the traditional
measures, which is due to the underlying assumption about the active, strategic
behavior of the investor. While bid and ask prices are valid for passive investors
who forgo their own search and choose to trade with a dealer, the LRR is more
appropriate for investors who are willing and able to conduct a strategic search
for a trading partner. In the former case, low expected purchasing expenses and
high expected sale receipts are to investor's disadvantage they constitute
trading costs and reduce returns. In the case of LRR, however, the investor is
assumed to take advantage of the high heterogeneity of market participants and low
market transparency. This way, she should be able to obtain a higher expected sale
price; at the same time, however, liquidity risk is also higher. Since both the
nominator and the denominator of the LRR ratio increase, the final effect is
unclear. It depends not only on the precise characteristics of the asset and the
market but also on the characteristics of the investor, in particular, her time
preference. The analysis of the relations betweens utility based approaches and
other liquidity measures is even more difficult. It depends almost entirely on the
utility function used in the concrete measure. The results achieved with the
approach proposed by Mok should generally lead to similar results as the
application of LRR when applied on the level of utility levels or QSD when applied
on the level of utility decreases due shorter sale horizons. However, the
conclusions may be entirely different when the assumed preferences are not
quadratic. ***
3.5 Relations between the Measures

231

A number of approaches to measuring liquidity and liquidity risk have been proposed
in this Chapter. The main conclusion from the analysis is the classification of the
measures into two groups: those concentrating on the expected outcome of
liquidation and those concentrating on uncertainty. This corresponds with the
decomposition of liquidity presented in section 1.1.2 of Chapter 1 into
marketability and liquidity risk. Since no complete picture of the problem is
possible without considering both dimensions, neither the traditional, nor the
probability-based, nor the liquidity risk measures can be viewed as sufficient for
all types of liquidity related decision problems. For the same reason, the
alternative measures should be viewed as most universal. Their quality depends,
however, on the compliance between the method according to which various aspects of
liquidity have been combined and the significance of these aspects for the concrete
decision problem. In particular, the relative importance of marketability and
liquidity risk as well as the freedom of action available to the investor (ability
to conduct a search) need to be taken into account. Summing up, the choice of the
best liquidity measure is at least as difficult as the choice of any other measure
of a complex phenomenon. The accuracy achieved with a certain approach depends not
only on its construction but also on investor's understanding of the terms that are
to be measured. In practice, it might turn out that a simpler ratio will give the
decision maker a better rationale for her investment decision than a theoretically
elaborate but intuitively intractable concept. Mainly for this reason, the analysis
in the next Chapter falls back on relatively simple, though possibly theoretically
imperfect measures of marketability and liquidity risk: expected net receipts from
liquidation and receipts' volatility, which are derived on the basis of the real
estate search model. Still, the issue of liquidity measurement remains a wide field
for further research.
Chapter 4 Liquidity as a Decision Criterion

Considerations in the former chapters concentrated mainly on the definition of


liquidity, methods of its appropriate description, and its measurement. Yet, the
main reason why investors are concerned with this issue is its relevance for
investment decisions. Since liquidity is one of the standard investment targets,
ignoring it will most probably result in a suboptimal allocation of capital.
Despite this fact, the vast majority of the existing investment analysis and
decision tools skip on this issue narrowing the scope of admissible assets to those
considered to be perfectly liquid. Obviously, this is inappropriate for a wide
range of assets including real estate. This drawback is dealt with in this Chapter.
In the course of the analysis in Chapter 1 two independent dimensions of liquidity
have been identified: marketability (or expected liquidity) and liquidity risk. As
demonstrated in Chapter 3, various popular measures of liquidity can be classified
according to this scheme. It seems therefore plausible to base the liquidity
management concept on these two dimensions as well. In terms of the search model
formulated in Chapter 2, they correspond with the expectation and the uncertainty
about liquidation receipts, which are random for illiquid assets. This approach
resembles the profitability-risk approach to investment analysis in the traditional
finance; in fact, the only difference is that the liquidation value instead of the
rate of return is used as the underlying variable. A straightforward advantage of
this analogy is the possibility of applying the same analysis tools, in particular,
the most popular and well researched meanvariance analysis. Combining the latter
approach with conclusions from the search theoretical analysis allows determining
the optimal liquidation strategy of a liquidity risk-averse investor as well as
enhancing the traditional portfolio optimization techniques with the liquidity
criterion. The Chapter is organized as follows: The general mean-variance decision
framework is presented at the beginning followed by the application of this
framework to the problem of strategic liquidation. By defining a "liquidity
efficient frontier", it is possible to identify the set of rational liquidation
strategies. The implications differ substantially when liquidation of whole
portfolios rather than of single assets is considered.
234

Chapter 4: Liquidity as a Decision Criterion

The conclusions have also consequences for the notion of liquidity. In particular,
the subjectivity of this characteristic vanishes as soon as a simultaneous sale of
liquid and illiquid assets is allowed. This is the subject of section 4.3. Finally,
liquidity is implemented in the portfolio selection framework. Planned portfolio
liquidation at the end of the investment horizon and unexpected, premature
liquidation are considered separately. In the first case, liquidity is allowed for
by correcting expected returns and market risk; in the second case, measures of
liquidity are introduced as separate optimization criteria. Like in former parts of
the book, also in this Chapter the analysis is limited to the liquidation case only
and focuses on real estate. This is mainly for better tractability of the results
as the same logic applies to the purchase case and the conclusions are also valid
for other highly illiquid assets.

4.1.

Investment Decisions in the Mean-Variance Framework

The mean-variance decision framework, which is the most distinctive one within the
Modern Portfolio Theory (MPT), dates back to Markowitz (1952). It was enhanced by
Tobin (1958) and further developed by numerous researchers becoming probably the
most popular tool of portfolio analysis and selection. The model combines the idea
of risk reduction by diversification, which is crucial for the most of today's
finance thought, with a relatively simple methodical approach allowing its
implementation even on personal computers. It is therefore appealing for both
scientists using it as a starting point for further research and practitioners
seeking optimal (or at least reasonable) combinations of investments. The
presentation of the concept is conducted in three steps: definition of the notion
of efficiency with respect to multiple decision criteria, presentation of the mean-
variance-based portfolio selection problem, and its extension by allowing for risk-
free investments. It is based mainly on Levy/Sarnat (1984) and Elton et al. (2003),
but the foundations of the portfolio theory can be found in practically any
investment text-book. The purpose of this section is to establish the foundation
for an analogous liquidity management concept presented further in this Chapter.
4.1.1. The Efficiency Criterion

If investment alternatives could be evaluated on the basis of only one criterion,


choosing the optimal one would be trivial. Imagine an investor concerned only about
investment's expected profitability obviously, she should invest her whole
capital in
4.1 Investment Decisions in the Mean-Variance Framework

235

one asset that offers the highest expected rate of return. Individuals with such
simple attitudes are, however, only seldom in reality. In most cases, further
criteria need to be considered constituting a non trivial trade-off. The decision
problem refers then to the optimal combination of the relevant criteria achieved
with the concrete choice of assets. In consequence, the notion of optimality
depends on investor's subjective preferences with respect to the considered
criteria. Even then, however, some alternatives are likely to exist that would not
be preferred by any rational individual; they are said to be inefficient. In
contrast, the group of investments that might be desirable for at least some
investors is said to be efficient. The efficiency principle is a decision rule for
dividing all potential investments into two exclusive sets: the efficient and the
inefficient. Thus, the choice of investments or portfolios under multiple decision
criteria can be accomplished in two steps: first, the set of efficient alternatives
is identified, and then, the final choice is made from among this set according to
investor's preferences, which are usually described by a utility function.401 The
key decision variables in the original portfolio theory are returns. They are
considered to be random and accordingly described by a probability distribution.
This assumption allows defining a very general efficiency principle: stochastic
dominance. It does not require the knowledge of investor's precise preferences but
implies some of their properties. According to the first degree stochastic
dominance (FSD) one alternative dominates (is more efficient than) another
alternative if for each return level the cumulative probability of achieving it is
higher for the first one than for the second one. Following this logic the
alternative X in Figure 4-1 dominates Y and Z since FX(R)>FY(R) and FX(R)>FZ(R) for
all R, but neither does Y dominate Z, nor does Z dominate Y. Hence, X is efficient
and Y and Z are inefficient. The only assumption behind this criterion is that
investors prefer higher returns to lower returns.

401

See Levy/Sarnat (1984), pp. 178-181.


236

Chapter 4: Liquidity as a Decision Criterion

Cumulative probability

Return Figure 4-1: First degree stochastic dominance

Two further degrees of stochastic dominance can be identified. The second one (SSD)
requires additionally that investors are risk averse, and the third one (TSD) adds
the requirement of a decreasing absolute risk aversion. However, as long as an
investment alternative is efficient according to the first degree stochastic
dominance principle, it is also efficient according to the second and the third
degree.402 Though very appealing as a theoretical concept, stochastic dominance
requires the knowledge of the entire probability distribution of returns. Such
knowledge is rarely available in reality; an assessment of returns' main
characteristics is usually all one can get. Another group of efficiency principles
concentrates therefore on selected distributional parameters (parameter preference
models).403 According to these principles, only those alternatives that are
inferior with respect to all parameters simultaneously are denoted as inefficient.
Although any number of decision relevant parameters can be used, most common is
their reduction to measures of profitability and investment risk. The mean and the
volatility of returns are predominantly used for this purpose constituting the
Markowitz's mean-variance (MV) criterion.404 According to it, an al402

403 404

For the derivations of the stochastic dominance criteria see Hadar/Russell (1969)
and Whitmore (1970). For an extensive research review see Bawa (1982). See Schmidt-
von Rhein (1996), p. 224. Although the MV-criterion in its most popular form was
proposed by Markowitz (1952 and 1959), it must be noted that the relevance of the
mean and the variance of returns for investment decisions has been proposed much
earlier, e.g., by Keynes (1937), Marschak (1938), or Hicks (1946). See also:
Levy/Sarnat (1984), p. 236.
4.1 Investment Decisions in the Mean-Variance Framework

237

ternative is efficient when no other alternative exists having simultaneously a


higher expected return and a lower return volatility (variance). Hence, the
alternatives X and Y in Figure 4-2 are efficient, and the alternative Z is
inefficient since it has both a lower expected return and a higher risk. In terms
of preferences, the MV-criterion requires that either the investor's utility
function is quadratic (i.e., it depends only on R and R2), or that the probability
distribution of returns is normal and, thus, fully defined by the mean and the
variance.405

U'3 Expected Returns

U'2 Y

U'1

U''3 U''2 U''1

X Z

Standard Deviation

Figure 4-2: Mean-variance efficiency and investment choice

As discussed in the section 3.3.1, the choice of the appropriate risk measure is
always connected with the understanding of this characteristic. Volatility is only
one of the possibilities, which owes it popularity to the easy handling. However,
other parametric approaches use alternative risk measures instead (e.g., semi-
volatility). Also further distributional parameters (e.g., skewness) can be added
as decision criteria. By doing so, a three- rather than two-dimensional efficiency
principle is considered.406 Although the approaches differ with respect to the
assumptions about the nature of investor's preferences, the general way of
reasoning about the efficiency of investment alterna405

406

The fact that returns of publicly traded assets are often considered to be normally
or nearly normally distributed is mostly named as the reason for the choice of mean
and volatility as decision parameters for portfolio selection. The argument basing
on the quadratic utility function, brought up originally by Markowitz (1959), seems
rather weak and is mostly rejected. See Markowitz (1987), pp. 52-56, and the
literature cited there. See Breuer et al. (1999), part III, for a review of
alternative parametric approaches to portfolio selection.
238

Chapter 4: Liquidity as a Decision Criterion

tives remains unchanged an efficient alternative is the one for which no other
alternative exists that is superior with respect to all parameters
simultaneously.407 As soon as the set of efficient investment alternatives has been
identified, the optimal choice can be made on the basis of investor's personal
preferences. This procedure can be depicted in the MV-diagram by drawing the
respective indifference curves. They represent combinations of expected returns and
return volatilities that lead to equal levels of utility. Higher curves (lying
further in the direction of the upper left corner of the diagram) indicate higher
utility levels and "steeper" curves indicate more riskaverse investors. In Figure
4-2, the alternative X would be preferred by more riskaverse individuals (U'), and
the alternative Y would be preferred by less risk-averse individuals (U''); neither
group would, however, prefer the alternative Z. 4.1.2. Diversification and Mean-
Variance Portfolio Selection

Determination of the efficient set and identification of the optimal investment


complicates when the investor is allowed to invest in more than one alternative.
The central idea of the MPT is the fact that the risk of an investment portfolio is
not equal to the sum of risks of its components. As long as the assets in the
portfolio do not follow exactly the same return path, some of the random negative
(positive) fluctuations of one asset may be offset by positive (negative)
fluctuations of another asset. Thus, fluctuations of the total portfolio value are
usually lower than the sum of fluctuations of its components some of the risk
vanishes due to diversification. If risk is measured with volatility, this effect
arises from the fact that the standard deviation (variance) of a sum or a weighted
average of random variables depends not only on the standard deviations (variances)
of these variables but also on the covariances between them. On the other hand,
there is no such effect with respect to expected returns. Thus, the parameters of a
two-asset portfolio with wX and wY percent of the total capital invested in X and
Y, respectively, are: E( w X R X + w Y R Y ) = w X E(R X ) + w Y E(R Y ) (4.1)

S( w X R X + w Y R Y ) = w 2 V(R X ) + w 2 V(R Y ) + 2 w X w Y Cov(R X , R Y


) (4.2) X Y

407

See Rehkugler/Schindel (1990), p. 94.


4.1 Investment Decisions in the Mean-Variance Framework The respective general
formulas for N assets are: E(R P ) = w i E(R i )
i =1 N

239

(4.3)
N N

S(R P ) =

w i2 V(R i ) + w i w j Cov(R i , R j )
i =1 i =1 j=1 ji

(4.4)

The portion of risk eliminated by adding an additional asset to an existing


portfolio depends on its correlations with other assets.408 It changes
proportionally for the correlation of 1, so that no diversification effect occurs
in this case, and can be reduced to zero for the correlation of -1. But even for
the correlation of 0 an over-proportional risk reduction is possible (see Figure 4-
3). Since neither the correlation of 1, nor the correlation of -1 occurs in
reality, it can be expected that the total portfolio risk decreases with every
additional asset, but it is not possible to fully eliminate risk this way.

Correlation = 0 Expected Returns Y

Correlation = +1

Correlation = 1

Standard Deviation Figure 4-3: Diversification effect in a two-asset portfolio409

The possibility of portfolio building has a direct effect on the determination of


efficient investment alternatives. It has to be viewed not in terms of single
assets but in
408

409

Since the correlation coefficient equals the covariance divided by the standard
deviations of both variables, it can be treated as a standardized covariance; it
takes values between -1 and 1 corresponding with precisely parallel variable
changes and precisely reverse changes, respectively. Based on Levy/Sarnat (1984),
p. 291.
240

Chapter 4: Liquidity as a Decision Criterion

terms of their portfolios. This results in a practically infinite universe of


different alternatives additional points in the MV-room become accessible by
varying assets' proportions in the portfolio. In effect, the graphical
representation of available investment alternatives as combinations of means and
variances of returns resembles a dense cloud rather than scattered points. Only
portfolios lying on the upper left boundary of this cloud are efficient they
constitute the so called "efficient frontier". Among the efficient portfolios,
there is one having the minimal achievable risk and denoted as the minimum-variance
portfolio (MVP), and one having the maximal expected return (MERP). While the MVP
is a combination of assets that yields the highest diversification effect, the MERP
consists always of only one asset the one having the highest expected return.

Expected Returns

U3

MERP POPT

U2 MVP U1

Standard Deviation Figure 4-4: Efficient frontier and portfolio selection

The choice of the optimal portfolio follows the same procedure as in the case of
single assets. Basing on investor's preferences, the combination of assets is
selected that offers the highest utility. It can be represented graphically by
drawing the respective indifference curves. Obviously, the investor prefers the
highest possible curve, which in the considered case is the one having only one
common point with the efficient frontier. The optimal portfolio is the portfolio
that corresponds with the MV-locus at the tangential point between the indifference
curve and the efficient frontier.
4.1 Investment Decisions in the Mean-Variance Framework 4.1.3. Portfolio Selection
with Risk-Free Assets

241

In the standard MV portfolio selection, all investments are assumed to be more or


less risky. Since no perfect negative correlations between assets are possible in
reality, it is also not possible to reduce risk to zero by building portfolios.
However, apart from risky investments, investors usually also have the possibility
to purchase (almost) riskfree assets. In particular, the interest earned on
treasury bonds, especially those emitted by the US government, is usually
considered to be free of any risk. Also the risk connected with most of the money
market investments is practically negligible. The effects of including a risk-free
alternative in an investment portfolio have been considered by Tobin (1958).410
Since the risk-free interest rate (RF) does not vary within the investment horizon,
its variance and volatility are zero; hence, its risk-return locus lies on the y-
axis. Furthermore, also the covariance of RF with any other investment equals zero.
In consequence, the risk of a combination of a risky asset with the risk-free
interest rate is proportional to the amount of the risky asset. Due to this
property, the risk-return locus of a portfolio containing a risk-free investment
can be presented graphically as a straight line connecting the respective risky
portfolio with the point on the y-axis corresponding with the risk-free interest
rate.

U Expected Returns

POPT

PM

RF Standard Deviation Figure 4-5: Portfolio selection with a risk-free interest


rate

410

See also Sharpe/Alexander (1990), pp. 166 ff., or Elton et al. (2003), pp. 84 ff.
242

Chapter 4: Liquidity as a Decision Criterion

Considering the modified problem, the question arises: which risky portfolio should
be combined with the risk-free investment? According to the efficiency principle,
an investor always prefers the highest expected return at a given volatility level.
Hence, it is optimal to choose a portfolio P on the efficiency frontier that yields
the highest RF-Pline when combined with the risk-free rate. This is the portfolio
for which the mentioned line is tangential to the efficiency frontier (see Figure
4-5); it is denoted as the "market portfolio" (PM). Assuming that not only risk-
free investing but also borrowing at RF is possible allows extending the line
beyond the PM point. It turns out that (unless PM was already investor's choice) it
is always preferable to purchase the market portfolio and combine it with the risk-
free investment rather than to invest in any other portfolio on the efficient
frontier. Thus, investors should select PM and "adjust" it to their own needs by
adding an appropriate portion of the risk-free asset. Note that the choice of the
optimal risky portfolio is independent of investor's individual preferences in this
case. This effect is denoted as Tobin's separation theorem as it separates the
portfolio selection problem form investor's attitude to risk.411 4.1.4. Limitations
of the MV-Criterion

The MV-efficiency principle and the portfolio selection methods arising from it
have become standard investment analysis tools. Aside from their theoretical
appeal, the ease of practical implementation was surely among the crucial
determinants of their great popularity. Statistical measures of returns, such as
expected values, variances, and covariances are usually assessed from historical
data, which are easily available for most public markets. Also the optimization
algorithms allowing the computation of the minimum-variance and the market
portfolio are relatively simple and operate even on personal computers.
Nevertheless, the model is subject to rigorous restrictions,

411

Basing on the Tobin's separation theorem, Sharp, Lintner, and Mossin developed the
Capital Asset Pricing Model (CAPM); see Sharpe (1964), Lintner (1965), and Mossin
(1966), as well as Elton et al. (2003), p. 293 ff. Note, however, that while the
CAPM is a descriptive market model, the portfolio selection framework discussed in
this section is a normative model of investor behavior. Hence, the separation
theorem refers only to investors facing the same set of investment alternatives.
4.1 Investment Decisions in the Mean-Variance Framework

243

which often seem to be overlooked in practice. The following four assumptions are
usually considered to be most important:412 (A1) investors are concerned only about
two moments of the return distribution: the expected return and the variance; (A2)
no market access restrictions exist; in particular, there are no transaction costs
or legal restrictions; (A3) all assets are perfectly divisible, i.e., it is
possible to purchase them in any desired quantities; (A4) all assets are perfectly
liquid, i.e., it is possible to sell and purchase them at will without discounts or
premiums and without affecting prices. The first assumption implies, as already
mentioned, either a quadratic utility function or normally distributed returns.
Assuming the first eventuality would enormously limit the scope of addressable
individuals; it seems rather unrealistic that a utility function in the form U(R) =
x1R + x2R2 (with x1 and x2 being respective parameters) is a very common one. The
second eventuality is, at least theoretically, easier to accept; it, requires,
however an efficient market.413 In this case, subsequent very short term returns
are independent and yield an asymptotically normally distributed random variable
when compounded to longer periods.414 However, since efficiency is disputable even
for highly liquid stock markets, also normal distribution of returns is
problematic.415 It is even more problematic for private markets that are widely
known to be inefficient, in particular, for real estate markets.416 Application of
alternative risk measures, especially those referring to downside risk, may be
advantageous is some cases, although it does not entirely solve the problem.

412

413 414 415 416

For an extensive review of the MPT constrains see Truxius (1980), pp. 44-50, or
Schmidt-von Rhein (1996), pp. 230-232. Note that market models based on the MPT,
such as the CAPM, require further assumptions, in particular, market participants
need to be homogonous. See FN 227. See also the discussion in section 2.3.1.5. See
the literature in FN 228 for empirical studies. For empirical studies on the
efficiency of real estate markets see Guntermann/Smith (1987), Gau (1987),
Case/Shiller (1989), or Clayton (1998).
244

Chapter 4: Liquidity as a Decision Criterion

The assumption about the lack of market access restrictions is obviously


unrealistic. There are both regulations preventing investments in certain assets
(e.g., limiting the access of foreign individuals to domestic markets, or
preventing pension funds from high-risk investments) and substantial transaction
costs encompassing broker or administrative fees. The latter can be especially
severe in the case of direct real estate investments. Fortunately, this limitation
can be solved relatively easily by correcting returns for additional costs and
introducing side constraints in the optimization algorithms.417 The latter method
can also be applied to ease the assumption of perfect divisibility of investments.
By allowing only investments of certain fixed amounts in each asset, a more
realistic optimal portfolio can be determined.418 Probably most severe and
especially important for this work is the assumption of perfect liquidity. This
issue has already been discussed in Chapter 1. In its original version, the MPT is
a one-period model and refers to a certain fixed investment horizon, which
corresponds with the assumed return period. However, if limited liquidity prevents
the investor from selling the investment as scheduled, the statistical parameters
of returns may alter resulting in a suboptimal asset allocation. A possible
solution is the correction of the original return series for the discounts accrued
in an immediate sale. Yet, as discussed in former chapters, immediate liquidation
of an illiquid asset may be, and in most cases is, not optimal. Furthermore, the
uncertainty component of liquidation still remains disregarded. Thus, there is no
easy way to cope with imperfect liquidity in the MV framework, and the MPT is
therefore applied practically only to highly liquid publicly traded assets. Finding
a method to adequately allow for liquidity in the standard portfolio selection
model is one of the central issues in this Chapter.

4.2.

Strategic Liquidation

Although the mean-variance decision framework presented in the former section has
been developed for the purpose of rational asset selection, it can be modified for
application to other decision problems, in particular those arising from the lack
of perfect liquidity. The first and probably most straightforward issue that
requires a strategic approach in the situation of imperfect liquidity is
liquidation of assets. Considerations regarding liquidation strategies for
perfectly liquid assets are pointless; since there is
417

418

For portfolio selection algorithms with transaction costs see Pogue (1970),
Patel/Subrahmanyam (1982), Davis/Norman (1990), Gennotte/Jung (1994), Li et al.
(2000, 2001), or Liu et al. (2003). See Jacob (1974) or Levy (1978).
4.2 Strategic Liquidation

245

only one market price that can be realized immediately, there is no need for a
strategic behavior. However, with heterogeneous opinions about the asset's value,
the lack of an organized trading system, and the necessity to search for a trading
partner, the choice of the best buying or selling strategy becomes nontrivial. The
following section offers an approach to optimal liquidation of illiquid assets
based on a combination of the mean-variance decision framework with the search
theoretical model. Despite the different character of portfolio selection and
liquidation decisions, the main principles remain the same; the only change is in
the target variable optimization is not applied to assets' rates of returns but
to liquidation values. A short review of the existing approaches to strategic
liquidation is presented first. The issue of efficiency of liquidation strategies
follows. By analyzing the loci of expected receipts and receipts' volatilities
associated with different reservation prices, it is possible to isolate inefficient
strategies, which should not be preferred by any investor and as such can be
excluded from further analysis. The remaining ones form a liquidity efficient
frontier. These considerations are then extended on liquidations of whole
portfolios containing either only illiquid or both liquid and illiquid assets. It
can be shown that the notions of efficiency and optimality of sale strategies
change as soon as more than one asset is liquidated at a time. 4.2.1. Literature
Review

Optimal liquidation is one of the central issues of the search theory; it has been
extensively discussed in Chapter 2. Since a liquidation strategy is usually defined
by the reservation price applied in the search process, the problem is reduced to
finding the optimal reservation price. This issue has been addressed in the context
of the basic search model in section 2.2.3, in the context of the Karlin's model in
section 2.2.4, and in the context of the real estate search model in section 2.3.2.
In all these approaches, the optimal liquidation strategy is interpreted as the one
that maximizes the expected net receipts from sale: this is the consequence of the
risk neutrality of the decision maker assumed in Chapter 2. A different way of
addressing the issue of strategic liquidation of financial investments in organized
markets was proposed by Bertsimas/Lo (1998). The focus of this approach is not on
the search for a trading partner, which is not necessary in an organized market,
but rather on the impact of trading on the market price. The authors con-
246

Chapter 4: Liquidity as a Decision Criterion

sider a strategy minimizing the expected cost of buying a fixed number of shares
within a given time horizon when prices are affected by random exogenous shocks as
well as executed trades. They define a trading trajectory as a sequence of amounts
of shares purchased in discrete time intervals. They show that the optimal strategy
(trajectory) can be presented as a combination of nave strategies of breaking the
total amount into equal portions and correcting for new information. Almgren/Chriss
(1998, 1999, and 2000/2001) use a similar framework to define efficient liquidation
strategies in public markets. However, in addition to the minimization of trading
costs, they assume that the trader is also concerned about the risk of liquidation.
Furthermore, they assume that trades have both a temporary and a permanent effect
on prices. The latter one is the only source of the drift in the equilibrium price
level, which would otherwise follow a random walk. Almgren and Chriss use the
expected liquidation cost and the variance of the liquidation cost to define the
efficient frontier of optimal liquidations. The optimal trajectory results from
investor's preferences with respect to these parameters; a linear utility function
is assumed.419 A related approach is applied by Dubil (2002). However, he operates
in a continuous time framework and also solves for the optimal liquidation horizon.
Within this horizon, the investment is liquidated at a constant rate per unit of
time, so the trajectory is a straight line. Dubil also allows for different forms
of impact functions. Furthermore, he also considers the consequences of a
correlation between the stochastic market impact and assets' returns. The presented
approaches, though granting valuable insights in the problems encountered when
liquidating illiquid assets, have major weaknesses. The search theoretical models
based on the maximization of expected receipts ignore the risks arising from the
lack of perfect liquidity. They can yield acceptable results when the investor is
risk-neutral but are clearly inappropriate for risk-averse individuals. The methods
focusing on liquidation trajectories mostly include risk considerations, but they
refer only to public markets and only to certain aspects of liquidity, i.e., to
depth and partially to resiliency. These shortcomings can be overcome by merging
the two approaches. On the one hand, by applying the search theory to model
liquidation receipts, it is possible to obtain very general results that are valid
also for direct markets. On the
419

The linear utility function used by Almgren and Chriss allows the interpretation of
the result in term of Value at Risk; see also section 3.3.3.3.
4.2 Strategic Liquidation

247

other hand, a two dimensional mean-variance approach based on both the expectation
and the uncertainty about outcome of liquidation ensures that investors' attitude
to risk is adequately regarded. 4.2.2. Efficiency of Liquidation Strategies

An optimal liquidation strategy is the one that results in the best possible
outcome. However, in order to identify it, a target variable, i.e., a clear
criterion for the evaluation of outcomes is required. In the case of asset
selection, rates of return are used for this purpose assets yielding higher
returns were preferred to those yielding lower returns. In the case of strategic
liquidation, net (discounted) receipts from liquidation are a natural candidate for
a target variable. Alternatively, its variations, such as the liquidity discount or
the implied spread, could be used. As soon as investors are assumed to be risk-
averse, the one-dimensional notion of optimality based on expeted sale recipts is
not sufficient, and the uncertainty about the liquidation outcome needs to be
considered as an additional decision criterion. However, with more than one
criterion, evaluation of liquidation strategies becomes substantially more complex.
Although possibly superior with respect to the expected outcome, some strategies
may proof inferior with respect to risk. Thus, the combination of both criteria
needs to be considered. In consequemce, similarly as in the case of asset
selection, the notion of optimality depends on investor's preferences. However, it
is also possible that certain strategies lead to lower expected receipts and higher
uncertainty than other strategies and are therefore not preferred by any investor.
Thus, similarly as assets or portfolios of assets, liquidation strategies can be
classified as efficient and inefficient. The latter should be excluded from further
analysis. Regarding the liquidation outcome as random, the analysis of liquidation
strategies' efficiency should be based on probability distributions of net receipts
resulting from these strategies. In the most general approach, whole distributions
should be considered since they contain all possibly relevant information. The
concept of stochastic dominance can be applied at this point. According to the FSD,
one strategy dominates another strategy only if the probability of achieving any
level of net sale receipts is higher for the first one than for the second one;
further degrees of stochastic dominance can be defined analogically. The main
practical problem is the determination of the respective probability distributions.
It can be solved by referring to a search model
248

Chapter 4: Liquidity as a Decision Criterion

of sale. This approach allows computing, or at least estimating, the probabilities


of sale receipts for certain strategies defined as reservation prices. Thus, with
sufficient computational effort, it should be possible to plot cumulative
distribution functions of net receipts for different reservation prices and to
determine whether some of them are dominated by other. An example of such analysis
conducted using a simulation technique is presented in Figure 4-6. The conclusion
is that the strategy Z is dominated by the strategy X for lower receipts' levels
and by the strategy Y for higher receipts' levels.

100% 90% 80%

Cumulative Frequency

70% 60%

X
50%

Y
40%

Z
30% 20% 10% 0% 0,0 0,2 0,4 0,6 0,8 1,0 1,2 1,4 1,6 1,8 2,0

Net Sale Receipts

Figure 4-6: Stochastic dominance of liquidation strategies420

Since search theoretical models allow estimating the probabilities for different
levels of sale receipts without falling back on large amounts of empirical data,
the application of the stochastic dominance concept seems to be easier than for
asset returns. Nevertheless, analytical proves of efficiency will usually not be
possible leaving a simulation as the only available solution. In this case,
however, only a finite number of
420

Computation on the basis of a Monte Carlo Simulation with 10.000 runs and following
parameters: offer volatility = 15%; rent = 5%; trend factor = 5%; discount rate =
15%; offer frequency = 52 p.a.; normally distributed market changes (A) with
volatility of 5%. X corresponds with the reservation price of 1.4, Y with the
reservation price of 1, and Z with the reservation price of 1.2.
4.2 Strategic Liquidation

249

search strategies and receipts' levels can be analyzed. Even with an enormous
computational effort one can never be sure whether some other, not reviewed
strategy exists that would dominate any other. Hence, it seems more practical to
concentrate only on certain parameters of receipts' distributions. In analogy to
portfolio selection models, it seems reasonable to limit their number to only two:
one referring to the expected outcome of liquidation (marketability) and one
referring to liquidity risk. Like in the traditional mean-variance approach, the
expected value and the variance (or the standard deviation, i.e., volatility) of
net sale receipts can be used as respective decision citeria. In this sense, only
those liquidation strategies are efficient which do not simultaneously yield a
lower expected value of receipts and a higher receipts' volatility than any other
strategy. While using expected receipts as a measure of marketability is largely
unproblematic, the use of volatility as a liquidity risk measure is subject to
several difficulties. The main problem arises in the context of investor's
preferences. As discussed earlier, the MV criterion holds only if either investor's
utility function is quadratic with respect to the considered (random) target
variable, which in this case is the outcome of sale, or the probability
distribution of this variable is normal. While the first condition leads to a very
restrictive assumption about investor's preferences and is therefore mostly
rejected, the second one is fulfilled only in certain cases. As discussed in
section 3.3.3, simulations show that sale receipts resulting from the real estate
search model are roughly symmetrically distributed only if the discount rate is
level with total expected returns from the property (i.e., expected appreciation
plus rental income). Otherwise, the distribution is skewed and clearly not normal.
Hence, in some situations, volatility may not be compliant with investor's notion
of risk. This will especially be the case when the sale is forced by unexpected
liquidity problems or by unusually profitable alternative investment opportunities
since discount rates are high then. Alternative approaches, especially those based
on the idea of downside risk (see section 3.3) should provide better results in
such cases. Nevertheless, the MV approach is followed in this Chapter mainly due to
the possibility of obtaining analytical solutions. Furthermore, what should not be
underestimated, it is by far the most popular risk measure in quantitative finance,
well established in the financial community, what makes it more easily acceptable
by practitioners. Using volatility also makes it easier to borrow from existing
approaches, like the MPT. Despite the mentioned drawbacks, it should still yield
satisfactory results in a number of typical liquidation situations. In other cases,
one
250

Chapter 4: Liquidity as a Decision Criterion

should consider substituting volatility (variance) with an alternative risk


measure. The general way of reasoning would not change and most of the conclusions
valid for volatility should also hold for other measures, but model mathematics is
likely to complicate substantially preventing an analytical solution. Still, it
might be an interesting subject for further research. Further considerations build
on the real estate search model presented in Chapter 2, although other versions of
search models can be applied as well. Conclusions can therefore be considered as
representative for a whole family of analogical problems, not necessarily referring
to real estate. Receipts from sale are the key variable; in the considered case
they are defined relative to the average valuation of the property on the market.
The goal of the real estate seller is to achieve possibly high expected receipts
while keeping uncertainty low. In terms of the assumed measures, it means
maximizing the expected relative net receipts E() at a given level of receipts'
volatility S(), or minimizing S() at a given level of E(). The steering (strategic)
variable is the reservation price *, which is set by the investor arbitrarily and
determines the liquidation strategy. Figure 4-7 plots E() and S() dependent on the
reservation price.
4.2 Strategic Liquidation
1,4 0,4 0,35 Expected net receipts 1 0,3 0,25 0,8 0,2 0,6 0,15 Receipts' volatility
0,4 0,1 0,05 0 0,0 0,2 0,4 0,6 0,8 1,0 1,2 1,4 1,6 1,8 2,0

251

1,2

Expected Net Receipts

0,2

Reservation Price

Figure 4-7: Expected net sale receipts and receipts' volatility in the search
framework421

Since there are no infinities in the expected receipts and the receipts' volatility
in the typical case, and there are regions in which these statistics change in
opposite directions, investor's choice of the reservation price is not trivial.
Some combinations of E() and S() clearly dominate others, but at least for some of
them, expected receipts maximization and risk minimization constitute contradictory
goals. A locus of expected receipts and liquidity risk similar to the traditional
return-risk locus results. It can be depicted in the liquidity-MV room and takes
usually the form of a (slightly slanting) letter J as in Figure 4-8; each point of
the curve corresponds with a certain reservation price.

421

Combination of Figure 2-2 and Figure 3-2.

Receipts' Volatility
252
1,4

Chapter 4: Liquidity as a Decision Criterion

X
1,2

Expected Net Receipts

0,8

0,6

0,4

0,2

0 0 0,05 0,1 0,15 0,2 0,25 0,3 0,35 0,4

Receipts' Volatility

Figure 4-8: Locus of expected net receipts and receipts' volatility

Obviously, not all points in this chart are efficient. Upper left points are always
better than lower right ones as they simultaneously indicate higher expected and
more certain sale receipts. Hence, the point X in Figure 4-8 corresponding to the
(relative) reservation price of 1.32 dominates the point Y corresponding to the
reservation price of 1.39. Thus, only the points at the upper left peak of the J-
curve as well as in the lower left arm are efficient. However, the latter
correspond with very high reservation prices. Though formally efficient, they do
not seem to be a reasonable choice for a typical investor. Very low levels of
liquidity risk are in this case achieved at the cost of sacrificing a large part of
expected receipts. Only an extremely risk fearing individual could consider taking
this path. Moreover, the high reservation prices practically preclude a sale, so
that net sale receipts arise mainly from an (almost) infinite stream of rental
revenues in this case. Thus, an investor choosing a strategy from the lower left
arm of the J-curve would express her preference of not selling at all. Since the
focus of the analysis is on "typical situations", and the considered seller is
assumed to be truly interested in selling, this type of efficient sale strategies
is omitted in further considerations. Concentrating on "serious sellers" leads to
the definition of the liquidity efficient frontier encompassing only combinations
of E() and S() located in the upper left peak of the J-curve (see Figure 4-9).
Since the points on the curve refer to certain res-
4.2 Strategic Liquidation

253

ervation prices, this is equivalent to defining the set of efficient liquidation


strategies (reservation prices). It contains the strategy maximizing the expected
receipts (MaxE) and the strategy minimizing the receipts' volatility (MinV).

1,295

U3

U2

U1

MaxE

1,285

Expected Net Receipts

*opt
1,275

1,265

1,255

MinV

1,245 0,060

0,065

0,070

0,075

0,080

0,085

0,090

0,095

Receipts' Volatility

Figure 4-9: Liquidity efficiency frontier

The concrete choice of the reservation price depends on investor's utility


function. Knowing it would allow determining the solution that is optimal in the
analyzed case. More risk-averse investors with steeper utility functions would
prefer reservation prices locating them in the left part of the E()-S() chart and,
thus, accept lower but more certain receipts; less risk concerned sellers would
choose reservation prices leading to higher expected receipts at the cost of higher
risk. This choice can be presented graphically by drawing the respective
indifference curves in the liquidity MV-room, as presented in Figure 4-9. The
reservation price corresponding with the single tangential point of the highest
possible indifference curve (here U1) and the liquidity efficient frontier is the
optimal one (*opt). The mean-variance approach of identifying optimal liquidation
strategies is closely related to the utility based liquidity measurement presented
in section 3.4.2, especially to the approach used by Mok (2002a, b). These measures
are based on a specific utility
254

Chapter 4: Liquidity as a Decision Criterion

function and the choice of the reservation price aims at maximizing it. Thus,
liquidity is measured by the maximal achievable utility. If the utility function is
quadratic with respect to sale receipts, as assumed by Mok, it is fully determined
by the expected value and the volatility (variance). Maximizing utility is then
equivalent to finding the combination of E() and S() (or E(G) and S(G)) lying on
the highest possible indifference curve it corresponds with the tangential point
in Figure 4-9. The strategic choice of the reservation price derived in this
section on the basis of the mean-variance decision framework is therefore
implicitly incorporated in the utility based measurement. An advantage of the two
step approach, in which the efficient set of reservation prices is identified
before the individual decision on the basis of investor's preferences is made, is
the possibility of avoiding the choice of a concrete utility function. It is
sufficient to state that sellers should choose only the reservation prices on the
efficient frontier. This enables more general applications. 4.2.3. Liquidation
Strategies for Portfolios of Assets

Liquidation of only one illiquid asset was considered so far. As shown by using the
search model and applying the MV-efficiency criterion, the range of rational
liquidation strategies (reservation prices) can be limited to the efficient ones
only. However, the question arises whether the liquidity-efficient frontier remains
unchanged when not one but several illiquid assets are liquidated simultaneously.
The traditional MPT demonstrates that the portfolio perspective can change the
notion of efficiency utterly. Is it then, per analogy, possible that certain
reservation prices, which were efficient when a single sale was considered, will
not be efficient when a portfolio is liquidated? Or can an inefficient reservation
price become efficient in such situations?

4.2.3.1. The Liquidity-Diversification Effect


Consider for simplicity a simultaneous liquidation of two properties: X and Y. The
investor is obviously interested in the total receipts from selling both houses and
not in the separate receipts from each transaction. Since the results of the sales
are random, the total outcome can be viewed as a sum of two random variables.
Hence, its expected value is simply the sum of expected values, but the variance
depends also on the covariance between the sale receipts. Analogically to (4.1) and
(4.2) one can write: E (XY ) = w X E (X ) + w Y E (Y ) (4.5)
4.2 Strategic Liquidation

255 (4.6)

S(XY ) = w 2 V(X ) + w 2 V(Y ) + 2 w X w Y Cov(X , Y ) X Y


with: wX, wY - relative values of X and Y respectively

Obviously, as long as X and Y are not perfectly correlated, the volatility


(standard deviation) of XY is less than the sum of weighted volatilities of X and
Y. Thus, expected receipts from portfolio liquidation change proportionally to the
proportions of liquidated assets, but the volatility can be reduces more than
proportionally a liquidity-diversification effect occurs. This formal result is
very intuitive: with two independent liquidations, it is possible that while one of
the properties sells below the expectations, the other one exceeds them, so that
the total receipts fluctuate less than the receipts from selling each portfolio
component separately. This liquidity risk reduction effect should be even stronger
when multiple assets are liquidated, but it will probably approach some
undiversifiable limit.

4.2.3.2. Covariance of Gains


Like diversification of market risk, diversification of liquidity risk depends to a
great extent on the correlations (covariances) between portfolio components. In the
analyzed problem, however, not the co-movements of returns but the dependences
between realized sale receipts are relevant. In consequence, the interpretation of
the correlation coefficient is slightly different it can be equal to one
practically only if all assets in the portfolio are sold as a bundle. The buyer has
then the choice between taking all of them or none, and the same conditions apply
to the whole stake. However, this eventuality means that, in fact, only one asset,
consisting possibly of several parts, is liquidated. As soon as each liquidation is
conducted separately, i.e., there is an independent flow of bids on each asset, a
perfect correlation of receipts, either positive or negative, is virtually
impossible. If the liquidation processes are entirely detached, the correlations
are likely to be low, but there are at least two reasons why they should still
differ from zero. Firstly, sale receipts are not entirely decoupled from the
development of the respective markets. As the search for a buyer proceeds,
subsequent bids are subject to changes in the market situation, so that also the
eventually realized sale price is affected by this factor. Hence, correlations
between price levels on the markets to which the liquidated assets belong are
relevant for the correlations between the liquidation receipts. In particular, when
similar properties are liquidated, the link between the respective (sub)markets is
256

Chapter 4: Liquidity as a Decision Criterion

likely to increase the receipts' correlation. Note, however, that even with all
assets belonging to the same market (e.g., flats in one block) the correlation will
be less than one. The second reason for the mutual dependence of net sale receipts
is the fact that liquidation processes run simultaneously by the same investor are
seldom fully separated. The seller will probably utilize the available information
channels to notify potential buyers about all assets that have been put on sale.
This holds especially for the liquidation of real estate portfolios if similar
properties are to be sold, prospective buyers will most probably show interest in
more than one property. In effect, bids on different assets (properties) may not be
independent with respect to the arrival times and the valuation tendencies of the
bidders leading to a positive correlation of the sale receipts. Summing up, a non-
zero correlation between receipts from parallel sales of multiple assets may arise
from three sources: common market development, simultaneous offer arrivals, and
similar levels of parallel offers. The first one can be expressed as the
correlation between price changes (i.e., discrete returns) in analyzed markets. In
terms of the real estate search model, it corresponds with the correlation or
covariance between the respective uncertainty factors A. The two latter sources
are, however, very difficult to capture since they depend on individual marketing
methods of the sellers. They should play a bigger role when similar objects are
liquidated (e.g., two similar residences) but should be negligible for very
different objects (e.g., a residential and an industrial property). As it was not
possible to define reasonable proxies for these sources of receipts' correlation,
they are omitted in the further analysis. Still, one has to bear in mind that it
may result in an underestimation of the actual correlation values. The full
derivation of the covariance between net sale receipts in the real estate search
framework is presented in Appendix A.6.1. The covariance between market
coefficients AX and AY of cov(AX,AY) = XY is assumed. The following formula results
for the real estate search model:
4.2 Strategic Liquidation

257

cov(x , Y ) * - 1 * - 1 * - 1 * - 1 X Y Y = XY 1 - X +
X 1 - + Y Y X Y X Y1,X Y1,Y 2 2 * * 1 -
X1,X X - 1 1 - X1,Y Y - 1 X Y with: X1,X = Y1,X = (4.7)

X ( - X ) + X

(( - X ) + X )2

and X1,Y and Y1,Y defined respectively It is apparent from this presentation that
the covariance is zero when XY is zero, i.e., when considered markets are
independent. Furthermore, by analyzing the respective correlation coefficient,
i.e., cov(X, Y)/(S(X)S(Y)), it is easily stated that it is always strictly smaller
than 1 and larger than -1. For practical applications, a proxy of XY is required.
The easiest way to obtain it is by computing covariances between discrete returns
of price indexes for the considered markets. However, due to the way the receipts'
covariance has been defined in the formula (4.7), this approach is problematic.
Although the A's are annualized and as such comparable, they refer to market
changes occurring during the search, which can have different durations for
different assets. Thus, it is possible that AX refers to a change within a year and
AY to a change within a month. On the other hand, the empirically measured
covariance (correlation) between index returns always refers to exactly the same
period of time. This means that XY is not strictly compliant with the covariance of
assets' (discrete) returns. To ensure such compliancy only temporarily coincidental
changes in A's should be considered; hence, only the time horizon until the sale of
the first property should be regarded. In the computation of the receipts'
covariance, this can be allowed for by splitting the market change into two
components: one referring to the time while both assets remain unsold and the other
one referring to the time after the first sale; the empirical covariance of returns
refers then only to the first component. An attempt to follow this approach is
presented in Appendix A.6.2. It was possible to derive conditional receipts'
covariances provided that one of the prop-
258

Chapter 4: Liquidity as a Decision Criterion

erties is sold first. In order to compute the unconditional covariance, however, it


is necessary to know for each property the probability that it will be sold as
first. Unfortunately, it was not possible to find analytical solutions for these
probabilities and, thus, to provide the unconditional covariance formula. Using a
numerical approximation should allow accomplishing this task; however, due to the
computational complexity of this approach, the simpler formula (4.7) is used in the
following analysis. One has to bear in mind that it probably overestimates the
receipts covariance if the empirical return covariance is used for XY. However,
numerous simulations conducted for realistic cases of real estate investments
resulted in only negligible deviations of the simplified approach from the
numerically estimated correct receipts' covariance even when relatively large
differences between assets' search parameters were assumed.422 Hence, the
simplified approach should generally yield satisfactory results, especially when
only pure real estate portfolios are considered.

4.2.3.3. Portfolio Effect of Liquidation


This section addresses the consequences of liquidity risk reduction due to the
portfolio effect. For better tractability, several cases are considered separately.
Liquidation of identical assets using identical selling strategies is viewed first;
different strategies are allowed for in the next step; finally, liquidation of two
different assets is analyzed. When liquidating several identical properties (e.g.,
identical flats in the same building), it seems intuitive to apply the same
strategy to all them. Since the sale receipts are not perfectly correlated, a
reduction of risk due to the liquidity-diversification effect can be expected.
Assuming that all N properties have equal shares of 1/N in the portfolio, the
following volatility formula results:423

S(P ) =
with: i j
422

1 N -1 V ( ) + Cov(i , j ) N N

(4.8)

423

The simulation framework was analogical to the one discussed in section 2.3.4 in
Chapter 2. On the one hand, a series of approximately 1000 net sale receipts was
generated with a predefined contemporaneous covariance between market uncertainty
parameters. On the other hand, the simplified covariance formula with respective
parameters was applied. The simulation was repeated for different combinations of
search parameters and reservation prices. The differences between the correct and
the estimated covariances rarely exceeded 10%. The formula is easily derived from
(4.4). See also Poddig et al. (2003), pp. 157-159.
4.2 Strategic Liquidation

259

Figure 4-10: Volatility of net receipts from liquidation of a portfolio of


identical assets as a function of the reservation price and the number of
properties424

The volatility reduction depends on the liquidation strategy and on the number of
simultaneously liquidated assets. S() decreases with N for all reservation prices,
as presented in Figure 4-10; however, not only the general volatility level but
also the form of the volatility as a function of the reservation price changes with
N. Simulations have shown that the local minimum of S(), which could be observed
for single sales,
424

This and the following examples are based on following parameters: offer volatility
= 15%; rent = 5%; trend factor = 5%; discount rate = 15%; offer frequency = 52
p.a.; normally distributed market changes (A) with volatility of 5%. Properties
account equal shares of the total portfolio value and the correlation coefficient
between their uncertainty parameters is always one.
260

Chapter 4: Liquidity as a Decision Criterion

disappears when the number of assets is large.425 This fact has consequences for
the efficiency and the optimality of reservation prices. The results of simulations
for portfolios containing 1 to 100 assets are presented in Figure 4-11. Increasing
the size of the liquidated portfolio leads to a shift of the E()-S()-locus to the
left. Moreover, also the form of the locus and the set of efficient strategies
change slightly. Thus, an individual selling one flat should possibly proceed
differently than an institutional investor selling a portfolio of several hundreds
or thousands of identical properties. A strategy efficient in the first case can
prove to be inefficient in the second case.

1,4

1,2

Expected Net Receipts

0,8

0,6 1 Property 2 Properties 5 Properties 0,2 10 Properties 100 Properties 0 0 0,05


0,1 0,15 0,2 0,25 0,3 0,35 0,4

0,4

Receipts' Volatility

Figure 4-11: Efficiency of liquidation strategies for portfolios consisting of


multiple identical assets

Although the effects of portfolio liquidation are most distinct for large
portfolios, the preferred selling strategy may also change when only few assets are
sold simultaneously. In this case, however, despite the shift of the efficient
frontier to the left, the set of efficient reservation prices remains in most cases
nearly unchanged. As long as investor's indifference curves are parallel, there
should be no or only a slight effect on the optimal liquidation strategy. However,
if investor's risk aversion changes for higher utility levels, it is possible that
a different reservation price corresponds with the
425

See section 0.
4.2 Strategic Liquidation

261

tangential point of the higher indifference curve with the "new" liquidity
efficient frontier (see Figure 4-12). In effect, although the set of efficient
reservation prices remains practically the same, a different strategy is optimal.

1,34 1,32

U2

One Asset

Two Assets

U1

Expected Net Receipts

1,3

*opt, 2
1,28 1,26 1,24 1,22 1,2 0,03

*opt, 1

0,05

0,07

0,09

0,11

0,13

0,15

Receipts' Volatility

Figure 4-12: Liquidity risk reduction and the optimality of reservation prices for
two identical assets liquidated using the same strategy

Though it seems intuitive, it is not obvious that setting the same strategy for all
liquidated (identical) assets is optimal. It is by all means possible to use
different reservations prices. This should allow an investor to access new points
in the E()-S() room. The question is, however, whether such points would be
efficient. The analysis of this case is more complex since the choice of the
reservation prices affects not only the expected receipts and receipts'
volatilities but also the covariances (correlations) between receipts. No
analytical solution has been derived for this case, and the analysis was restricted
to a simulation of simultaneous liquidation of two properties.
262

Chapter 4: Liquidity as a Decision Criterion

Figure 4-13: Expected net receipts (a) and receipts' volatility (b) for two
identical assets liquidated using different reservation prices
4.2 Strategic Liquidation

263

Since the liquidation strategy in this case is defined by a pair of reservation


prices, the E()-S() charts analogical to Figure 2-2 and Figure 3-2 are now three-
dimensional as depicted in Figure 4-13. However, each strategy still corresponds
with certain values of expected receipts and receipts' volatility. Considering all
possible pairs of reservation prices and depicting them in the expected receipts-
volatility room yields the set of feasible liquidation positions; this time,
however, it resembles a "cloud" rather than a curve. Multiple simulations of this
problem led to very similar results the E()-S() combinations accessible by
applying a different reservation price to each property seem all to lie within the
borders set by the same-reservation-price strategy, as depicted in Figure 4-14.
This means that the "upper" part of the efficient frontier consists of pairs of
identical reservation prices they remain efficient and probably optimal for
average investors in most cases. However, new efficient points can arise for lower
levels of expected receipts and volatilities (e.g., the point *opt in Figure 4-14).
Especially more risk averse investors can achieve higher utility levels by choosing
these points.

1,4

1,2

Expected Net Receipts

0,8

*opt

0,6

0,4

0,2

Different Reservation Prices Equal Reservation Prices

0 0 0,05 0,1 0,15 0,2 0,25 0,3

Receipts' Volatility

Figure 4-14: Liquidity-efficient frontier for two identical assets liquidated using
different reservation prices

Another relevant case is the liquidation of multiple different assets. The first
difference to the liquidation of identical assets is that the parameters of the
receipts' distributions
264

Chapter 4: Liquidity as a Decision Criterion

are no longer the same. Obviously, this leads to different patterns of expected
receipts and receipts' volatilities and also to different optimal reservation
prices. The shapes of the E()- and S()-planes regarded as functions of the
reservation prices (analogue to Figure 4-13) are therefore asymmetric in this case.
Another new issue is the possibly different weighting of the assets in the
portfolio. Under certain circumstances, this may introduce a new strategic variable
to the liquidation problem. If the investor is in a position to decide on the value
or on the number of liquidated assets, she can use it to reach additional points in
the E()-S() room. The extent of the liquidity diversification effect depends then
not only on the applied liquidation strategies but also on the proportions of
liquidated asses (see Figure 4-15). In practice, however, the choice of the weights
is likely to be very limited, if at all possible. In the case of real estate, large
investment sums and lacking divisibility will prevent the arbitrary choice of
proportions in which properties are to be liquidated diminishing the importance of
this variable.

1,4

1,2

Expected Net Receipts

0,8

0,6

0,4 Property X 0,2 Property Y Portfolio XY 0 0 0,05 0,1 0,15 0,2 0,25 0,3 0,35 0,4

Receipts' Volatility

Figure 4-15: Liquidity risk reduction for two different assets liquidated in
different proportions

In effect, determination of the liquidity efficient frontier when multiple


different illiquid assets are liquidated becomes very complex. It requires the
analysis of all possible reservation prices as well as all feasible weights for
each of the assets. Simulations led
4.2 Strategic Liquidation

265

to the conclusion that although the efficient frontier consists in this case mainly
of the reservation prices that are efficient in the one-asset-liquidation case,
they are now efficient only in certain combinations. So, it is possible that, for
example, relative reservation prices of 1.15 and 1.25 are efficient when separate
sales of the properties are considered, but a combination of these prices becomes
inefficient when properties are to be liquidated simultaneously. Furthermore,
combinations of reservation prices which were formerly inefficient may turn out to
be efficient and even preferable for some investors. Further, more complex
liquidation scenarios can be considered by introducing additional decision
variables. For example, one can allow splitting an asset into several parts and
liquidating each part separately. This way, the initial problem of single asset
liquidation becomes a portfolio liquidation problem. An additional strategic issue
arises then how should the asset be split in order to reach the highest
efficiency frontier and the highest utility from liquidation? Another possibility
is to allow arbitrary timing of sales. Due to the random nature of the search
process, it is not possible to determine the sale time, but one can decide on the
moment when the sale process starts. In terms of the search model, this corresponds
with rejecting some of the first offers. Starting the search later than initially
intended means that potential sale chances, which would occur during this time, are
missed. In the traditional search framework, this kind of delay is pointless by
foregoing incoming offers, a chance of receiving an unusually high one is missed as
well. Even if one expects the market situation to improve in the near future, it is
still better to inspect any incoming offer and perhaps reject it than to ignore it.
However, there is one possibility when timing may be advantageous. If selling an
asset or even placing it on sale results in a temporary change of the offer
distribution, it might be preferable not to liquidate the whole portfolio at once
but to do it in several steps. Such situations may occur when the number of buyers
is limited and new ones arrive only slowly. Selling an asset of a certain type,
e.g., a residence in a certain area, takes then some of the potential demand for
further properties of this type out of the market. The remaining potential buyers
may have different valuations of the asset and, thus, offer lower prices. This
effect is closely related to the depth and partially to the resiliency dimensions
of market liquidity as discussed in section 3.1.2.4 if depth and resiliency are
low, i.e., the distribution of valuations by market participant is prone to rapid
changes due to trading activity and recovers only slowly to the initial
266

Chapter 4: Liquidity as a Decision Criterion

state, it might be advantageous to increase time intervals between subsequent


sales.426 Finally, one could extent the analysis to include the problem of
optimality of the remaining portfolio. If the investor is allowed to choose freely
which of the assets held in the portfolio are to be liquidated and in what
proportions, she should also consider her situation after the liquidation. While
optimizing the selling strategy may lead to the decision about selling certain
assets, it may turn out that the remaining holdings are suboptimal with respect to
other investment goals, e.g., they result in a very high market risk exposure.
Implementing such considerations would require a criterion of comparing the
improvement of investor's liquidity position with the possible deterioration of her
position in other aspects the utility theory seems to offer the most promising
approach to this problem. Since these and other possible enhancements substantially
increase the complexity of the model without modifying the central conclusions of
this Chapter, they are ignored in further considerations. Nevertheless, for certain
practical applications, they might increase the precision of the analysis. The
analysis of the effects of simultaneous liquidation of multiple illiquid assets led
to the conclusion that efficiency as well as optimality of liquidation strategies
need to be reviewed in such situations. Depending on the types and weights of the
liquidated assets, different strategies may prove to be efficient and, in
consequence, different strategies may be optimal. The implication for investors
holding portfolios of illiquid assets, such as real estate companies or funds, is
that the portfolio aspect should be taken into account when considering liquidation
strategies. By selling each property "on its own", possible efficiency benefits can
be lost. Another, more general consequence is that the notion of liquidity needs to
be redefined in certain cases it should refer to portfolios of assets instead of
single investments. This issue is discussed more thoroughly in the following
sections. 4.2.4. Simultaneous Liquidation of Liquid and Illiquid Assets

Only liquidation of illiquid assets has been considered so far. However, in the
reality investors seldom hold only illiquid assets. Their portfolios usually
contain some por426

Note that this aspect of liquidity is in the hub of the models by Bertsimas/Lo
(1998), Almgren/Chriss (1998, 2000/2001), and Dubil (2002). Since they consider the
problem of liquidating an asset portfolio on a market on which trading results in
changes of the price level, market depth and resiliency play the central role.
However, as already noted in section 4.2.1, these authors limit the scope of the
analysis to organized markets only. Thus, search for a buyer and strategies defined
by reservation prices are irrelevant in their models.
4.2 Strategic Liquidation

267

tion of perfectly or nearly perfectly liquid investments that are necessary to


maintain solvency. Among them are bank deposits, publicly traded stocks, or other
securities. Many institutional investors are even legally obliged to such holdings.
Strategic liquidation should be therefore considered also with respect to
portfolios containing both liquid and illiquid assets. According to the definition
provided in Chapter 1, perfectly liquid assets can be always sold (almost)
immediately at the current market price. Search for a buyer is pointless since no
market participant would ever offer any other price; hence, the relative sale
receipts are always equal to the asset's market value, i.e., E() = 1. Furthermore,
the lack of deviations from the market value means that there is no liquidity risk
involved in the liquidation, i.e., S() = 0. In the E()-S()-chart any perfectly
liquid asset is therefore represented by the point (0,1); it is labeled as L in
Figure 4-16. Another consequence of the lack of liquidity risk is that the
correlation with the receipts from selling any other not perfectly liquid asset
equals zero. This fact is of relevance when a combined sale of a liquid and an
illiquid asset is considered. Since the covariance and the correlation between them
is zero, and the volatility (variance) of the liquid asset is zero as well, both
the expected receipts and the receipts' volatility of such a portfolio change
linearly with the proportions of the assets. It can be presented graphically as a
straight line connecting the (0,1) point with the point of the J-curve of the
illiquid asset corresponding with the chosen reservation price (straight line in
Figure 4-16). Points on this line correspond with liquidation positions of an
investor who sells the illiquid asset using a certain strategy and simultaneously
sells the liquid asset at the market price. Furthermore, the line can be extended
beyond the point O by liquidating more of the illiquid asset than actually desired
and reinvesting the surplus receipts in the liquid asset. This corresponds with
simultaneous restructuring of the investment portfolio and increasing liquid
holdings.
268
1,7 U 1,5

Chapter 4: Liquidity as a Decision Criterion

Expected Net Receipts

1,3 O(*T) 1,1 L 0,9

0,7

0,5

0,3 0 0,05 0,1 0,15 0,2 0,25 0,3 0,35 0,4

Receipts' Volatility

Figure 4-16: Simultaneous liquidation of liquid and illiquid assets

Note that the described effect is analogue to the one occurring in the combination
of risky assets (portfolios) with a risk-free investment in the traditional MPT
(see section 4.1.3). Also here, the higher lines dominate the lower ones as they
allow higher expected receipts at the same level of uncertainty. The highest
possible, and thus the only efficient, is the line tangent to the J-curve
(liquidity efficient frontier). The tangential point O corresponds with a certain
reservation price denoted as p*T and referred to as the tangential reservation
price. Note that (in most cases) it is neither the one maximizing expected receipts
nor the one minimizing receipts' volatility. Instead of choosing a reservation
price corresponding with any other point on the liquidity efficient frontier, the
investor is able to reach higher expected receipts or lower receipts' volatility by
applying p*T and liquidating a part of the liquid assets' holdings at the same
time. The proportion of the liquid and illiquid investment depends on investor's
preferences it corresponds with the tangential point of the highest possible
indifference curve with the OL-line. The same logic can be applied when not a
single illiquid asset but a portfolio of illiquid assets is considered. The only
difference is that the tangential point does not correspond with a single
liquidation strategy but with a set of strategies for all assets. In
4.2 Strategic Liquidation

269

terms of the search theoretical approach, it is an array of reservation prices. In


analogy to the tangential reservation price, it is referred to as the tangential
array and denoted as p*T (bold). Note that the reservation prices in p*T do not
necessarily comply with the tangential reservation prices valid when the assets are
sold successively rather than simultaneously. Thus, the main conclusion from the
former section saying that a different liquidation strategy may be optimal when
selling a portfolio of assets holds also in this case. Note that an objectively
optimal reservation price exists in the above case any investor, independent of
her individual attitude, should choose p*T. Preferences are relevant only for the
choice of the proportion in which liquid and illiquid assets are to be sold. If
this reasoning was valid for all investors on the market, it would mean that anyone
selling the asset should demand at least p*T. In effect, this should be the only
price paid on the market and the divergence of valuations should disappear.
Obviously, this idealized scenario does not occur in reality, and the objectivity
of the tangential reservation price is disturbed by other factors. Indeed, there
are several reasons why investors' reservation prices should deviate from p*T.
Firstly, the parameters of the search model are to a great extent subjective.
Constants such as the discounting rate or the arrival rate of potential buyers
depend on seller's attitude and her efforts. In effect, also the form of the J-
curve and the position of the liquidity efficient frontier are subjective, and so
are also the tangential reservation price. Secondly, the above conclusion does not
necessarily hold if not a single liquid and a single illiquid asset but a portfolio
of (multiple) illiquid and liquid assets is considered. As noted above, the
tangential reservation price becomes then an array of reservation prices that are
not necessarily identical with those which would be optimal in the single-asset-
liquidation case. Since each investor holds and liquidates a different combination
of illiquid assets, a different tangential reservation price (array) applies in
each case. The idea of a universal reservation price common for all investors has
to be therefore rejected. Still, objective optimal reservation prices may be true
in many realistic cases. Especially in the real estate branch, only one property is
often liquidated at a time making portfolio considerations unnecessary. Also the
characteristics of institutional investors are often similar, so that similar
parameters of the search model can be applied. Some kind of a common p*T value may
exist in such cases.
270

Chapter 4: Liquidity as a Decision Criterion

There are two practical difficulties connected with the implementation of a


strategy comprising of the liquidation of a liquid and an illiquid asset. Firstly,
realizing the required proportion between these two assets (asset classes) may
prove problematic due to the limited divisibility of illiquid assets. It is rather
impossible to adjust the amount of the real property that should be sold it can
either be sold as a whole or not at all. Therefore, only the portion of the liquid
asset can be adjusted. The strategic decision in this case is not about the
reservation price that should be applied but about the amount of the liquid asset
that should be sold together with the property. The second issue concerns finding
the actual value of the tangential reservation price. Techniques known from the
traditional portfolio theory may be applied here.427 The simplest approach seems,
however, to look for the reservation price maximizing the slope of the OL-line: E
( p *) - 1 p *T = arg max p* S( p *) (4.9)

This problem can be solved numerically. As long as the expected net receipts and
the receipts' volatility are finite, a unique solution exists. It is also worth
noting that p*T computed this way is closely related to the reservation price
maximizing the Liquidity Risk Reward defined in section 3.4.1 (see also section
4.3.2).

4.3.

Optimal Liquidation and the otion of Liquidity

Considerations in the former sections involved the issue of a liquidation strategy


that is optimal not only with respect to the expected receipts but also with
respect to the uncertainty about the receipts. The strategic liquidation problem
resulting from this twodimensional approach is more complex than the sole
maximization of the expected search value discussed in Chapter 2. In particular,
more than one reservation price can be efficient at a time. The problem becomes
even more complex when not a single asset but a portfolio of assets is liquidated.
However, implications regarding the strategic behavior of investors selling
illiquid assets are not the only conclusion from the search theoretical approach.
It also adds a new perspective to the liquidity problem itself. This issue is
discussed in the following subsections.

427

See Rudolf (1994) for a review of portfolio optimization techniques.


4.3 Optimal Liquidation and the Notion of Liquidity 4.3.1. Liquidity in Terms of
Efficient Liquidation Strategies

271

The starting point for the search theoretical definition of liquidity is the
concept of efficient liquidation strategies. As stated in the former sections, a
set of efficient liquidation strategies can be determined for each illiquid asset.
Each of these strategies leads to a different combination of E() and S(), and none
of them is clearly superior or inferior to any other efficient strategy; the choice
of the best one depends solely on the preferences of the investor. Hence, as long
as the analysis is not addressed to a concrete individual, it cannot be limited to
a single strategy but needs to encompass all potentially interesting, i.e.,
efficient ones. Following this logic, one can attempt to judge assets' liquidity by
the form and position of their liquidity efficient frontiers.

Expected receipts

U'3 U'2

U'' U'1 U'' U''

Z Y Receipts' volatility Figure 4-17: Asset liquidity in terms of liquidity


efficient frontiers

Efficient liquidation frontiers for three exemplary assets are depicted in Figure
4-17. It is clear that asset X dominates asset Z it allows achieving higher
expected receipts at a lower risk for any liquidation strategy. However, no such
statement is possible for other pairs of assets (X and Z, and Y and Z). X sells on
average at a better price than Y for higher receipts' volatilities, but a lower
level of receipts' volatility is possible with Y. Analogically, Z is burdened with
higher liquidity risk than Y for lower levels of expected receipts, but allows
achieving high values of E(), which are not accessible with Y. Basing on the above
considerations, one asset can be considered more liquid than another asset if it
yields at least as high net receipts from sale and at least as low re-
272

Chapter 4: Liquidity as a Decision Criterion

ceipts' volatility as the other asset independent of the reservation price. As soon
as one of these conditions is not fulfilled, no definite statement about assets'
relative liquidity is possible without assuming investor's preferences. In this
sense, X is more liquid than Z, but the liquidity relation between X and Y as well
as between Y and Z is indefinite and depends on investor's preferred reservation
prices. For example, a more liquidity risk-averse individual (with utility levels
U') would consider the alternative Y more liquid, and a less liquidity risk-averse
investor (with utility levels: U'') would regard X as more liquid. At this point,
it is again necessary to stress the difference between the two-dimensional approach
based on expected sale receipts and liquidity risk and the traditional notion of
liquidity based on market breadth, depth, and resiliency. Note that the assumption
that the investor is able to influence the receipts from selling an asset by
adjusting the reservation price implies the ability to conduct an active search. In
contrast, the traditional liquidity concepts assume that the investor accepts the
market situation as it is, including the price level. Hence the notion of liquidity
presented in this section is addressed predominantly to individuals who are in a
position to behave strategically. This may not apply to many smaller investors, as
they have neither the means nor sufficient information to apply a strategic search.
The traditional approach may be still more appropriate for such investors. 4.3.2.
Liquidity with Liquid and Illiquid Assets

The above notion of liquidity needs to be modified when simultaneous sale of a


liquid asset is allowed. As discussed in section 4.2.4, reservation prices
associated with the liquidation efficient frontier are then not efficient any more.
Due to the possibility of combining the sale of an illiquid asset with the sale of
a liquid one, new, more efficient combinations of expected net receipts and
receipts' volatilities become accessible. The only efficient liquidation strategy,
independent of investor's preferences, is then the tangential one. A liquidity
efficient line representing portfolios with different proportions of the liquid and
the illiquid asset results. Such efficient lines can be drawn for all illiquid
assets and correspond with the respective tangential reservation prices. Since
their efficient liquidation frontiers usually differ, also the lines are asset
specific.
4.3 Optimal Liquidation and the Notion of Liquidity

273

Expected receipts

p*T, A X p*T, C p*T, B Z

Y Receipts' volatility

Figure 4-18: Asset liquidity in terms of liquidity efficient lines

As stated in the former section, one asset is considered to be more liquid than
another asset if it leads to higher expected net receipts from sale and lower
receipts' volatility for any liquidation strategy. With the simultaneous
liquidation of liquid assets, this definition requires that the liquidity efficient
line of the first asset lies higher than the efficient line of the second asset.
Since all efficient lines start at the point L and cannot intersect, it is always
possible to unambiguously identify more and less liquid assets in this case.
According to this modified notion of liquidity, asset X in Figure 4-18 is the most
liquid one, and asset Z is the least liquid one. In general, it holds that the
steeper the slope of the tangential line, the higher asset's liquidity. In this
sense, the slope can be treated as a liquidity measure. It is easily computed as:
Slope = E( *T ) - 1 S( *T ) (4.10)

Note that the slope of the efficient line corresponds with the Liquidity Risk
Reward defined in section 3.4.1. This property makes LRR an especially appealing
liquidity measure. Not only it can be interpreted in terms of a liquidity
performance measure, but it also corresponds with the optimal liquidation strategy
in the case of a simultaneous sale of a liquid and an illiquid asset. An important
advantage of this approach is the independence from investor's preferences it
allows comparing assets with respect to liquidity without the necessity of assuming
the shape of seller's utility function.
274 4.3.3. Liquidity of Assets in Portfolios

Chapter 4: Liquidity as a Decision Criterion

As discussed in section 4.2.3, a different liquidation strategy may be optimal when


an asset is liquidated as a part of a portfolio than when it is liquidated on a
standalone basis. It is therefore straightforward that also its liquidity may be
different if other assets are sold at the same time. The general conclusions from
the two previous sections retain their validity in this case. One portfolio can be
viewed as more liquid than another portfolio if it offers higher expected receipts
and lower receipts' volatility for any combination of liquidation strategies
(arrays of reservation prices). Furthermore, if a simultaneous sale of a liquid
asset is allowed, a portfolio is more liquid if the tangential line corresponding
with it is higher than the line of the other portfolio. Note that as soon as a
portfolio of assets is considered, only the liquidity of the whole portfolio
matters. It is pointless to compare expected receipts and receipts' volatilities of
its components because the reservation prices assigned to them have been optimized
in the context of the portfolio and are not necessarily identical with those which
would have been chosen if the assets were sold separately. Hence, due to the
liquidity diversification effect, it is possible that a portfolio of highly
illiquid assets is more liquid than some other asset, which, in turn, is more
liquid than any single component of the portfolio. Nevertheless, it might be
worthwhile to ask about the contribution of each of the assets to the liquidity of
the whole portfolio, or, in other words, to ask how much of the portfolio's total
liquidity risk can be associated with each single asset. The answer would provide a
different notion of liquidity than those regarded so far it would refer to the
relative liquidity within a group of assets. This approach can be interesting for
investors willing to identify the sources of their portfolio's (il)liquidity. The
contribution of an asset to the liquidity risk of a portfolio is twofold: through
the inherent liquidity risk associated with the asset when it is sold separately,
and through its contribution to the liquidity diversification effect. The latter
component is determined by the level of correlations between the sale receipts of
the considered asset and the sale receipts of other assets in the portfolio. In
this sense, relative liquidity risk in the portfolio context can be defined as the
"stand-alone" risk reduced by the additional liquidity diversification caused by
the assets' inclusion in the portfolio. Hence, even if an asset has a high level of
own liquidity risk, it still might prove to be relatively less risky due to the low
correlations of its receipts with the receipts of other assets.
4.3 Optimal Liquidation and the Notion of Liquidity

275

An interesting possibility to translate the concept of relative liquidity within a


portfolio into an operational measure is based on the Beta-coefficient from the
Single-Index Model.428 Beta is defined as the coefficient in the regression of
asset's returns on the returns of some underlying index. It is interpreted as an
indicator of the "systematic market risk", i.e., it measures the undiversifiable
market risk associated with the asset. In a more general sense, Beta measures the
contribution of an asset to the risk of a perfectly diversified portfolio (market
portfolio) containing also the analyzed asset. It is estimated as the covariance of
asset's returns with the returns of the market portfolio divided by the variance of
the market portfolio's returns.429 The reasoning behind Beta can be relatively
easily applied to liquidity risk. In only requires substituting returns with sale
receipts and market portfolio with the portfolio that is to be liquidated. The
measure obtained this way expresses liquidity risk of a single asset in a portfolio
in which all reservation prices have been set optimally. In this sense, Liquidity
Beta (LBeta, L) is a measure of the undiversifiable liquidity risk. However,
contrary to the original market risk Beta, L-Beta refers only to a concrete
portfolio of a concrete investor and as such is portfolio-specific. Applying the
definition of Beta to sale receipts yields the following formula for the Liquidity-
Beta of an asset i within a portfolio P: Li ,P = cov(i , P ) S2 (P ) (4.11)

Since the asset i is a part of the portfolio P consisting of N assets, the L-Beta
formula can be alternatively presented as:430

w i S2 (P ) + cov(i , j ) Li ,P =
j=1 ji

S (P )
2

(4.12)

428

429 430

See, e.g., Levy/Sarnat (1984), Chapter 10, Sharpe/Alexander (1990), section 9.1, or
Elton et al. (2003), Chapter 7. See Levy/Sarnat (1984), p.429, Sharpe/Alexander
(1990), p. 204, or any investment handbook. The transformation of (4.11) into
(4.12), although not standard, is easily accomplished by presenting the portfolio
return in the nominator as a weighted sum of components' returns.
276

Chapter 4: Liquidity as a Decision Criterion

The covariances of the asset i with other components of the portfolio can be
computed within the real estate search model with the formula (4.7), and the
volatilities of the asset i and of the portfolio P are given with the formulas
(3.28) and (4.6), respectively. Note that L-Beta can be computed for any set of
reservation prices it does not necessarily need to correspond with an efficient
E()-S()-combination. However, for practical application, it seems reasonable to
limit the scope of considered liquidation strategies to the efficient ones. If a
simultaneous liquidation of a liquid asset is allowed, there is only one efficient
set of reservation prices the tangential one. Thus, in the most general case of
liquidation of a portfolio containing liquid and illiquid assets, LBeta should be
computed on the basis of p*T. Only then its interpretation as a measure of assets'
relative liquidity risk in an optimally liquidated portfolio holds without
additional assumptions about investor's preferences.

4.4.

Portfolio Selection with Illiquid Assets

Former sections of this Chapter dealt with the problem of strategic liquidation,
i.e., with the choice of a strategy (reservation price) that leads to the optimal
outcome of the sale. It has been demonstrated that such a strategy depends not only
on the characteristics of the liquidated asset but also on the circumstances of the
sale. However, this issue is only relevant when the illiquid asset has already been
purchased. The question whether such an asset should at all be included in a
portfolio and in what proportion has not been addressed so far. Yet, this issue is
highly relevant for most investors to which liquidity is one of the central
investment goals (see section 1.4.2). Therefore, the problem of optimal portfolio
selection with illiquid assets is addressed in the following subsections. The mean-
variance framework presented in section 4.1 is a standard tool used for portfolio
selection. Still, as discussed in section 4.1.4, the scope of its applications is
limited due to strict assumptions. Many of them have been loosened in various
extensions to the basic model proposed by numerous researchers. For example,
transaction costs can be allowed for by correcting historical returns, and the
problem of imperfect divisibility of assets can be coped with by using integer
optimization.431 However, imperfect liquidity of assets still remains to a great
extent an open issue. Some of the existing approaches are presented in the next
section. However, as is seems, they do not
431

See literature references in FN 417 and 418.


4.4 Portfolio Selection with Illiquid Assets

277

fully allow for the effects caused by the inclusion of illiquid assets in
investment portfolios. A two-dimensional search theoretical approach offers a
solution to this problem. In the course of the analysis, it turned out that
different approaches are necessary when a "planned" and an "unexpected" liquidation
is considered. While a correction of expected returns and return volatilities is
sufficient in the first case, an extension of the decision framework with further
variables is necessary in the second case. 4.4.1. Literature Review

While literature on liquidity is generally extensive, there is surprisingly little


research on the impact of asset illiquidity on portfolio selection. The existing
approaches can be divided into three groups. The first and probably the largest one
addresses illiquidity understood as "impossibility to sell". However, since
unsalability can be seen as an immanent characteristic of very few assets,
practical relevance of these methods is limited. Approaches in the second group
allow for trading illiquid assets but impose certain restrictions, usually with
respect to the transaction size or the liquidation time. Although they use a more
appropriate definition of illiquidity, they are mostly based on strongly simplified
market models intended to demonstrate certain effects associated with the lack of
liquidity. Thus, they are not applicable to concrete decision problems. Finally,
the third group consists of approaches treating liquidity as a separate decision
criterion; to some extent they also provide tools for practical implementation.
Unfortunately, there are only few papers addressing portfolio selection with
illiquid assets in this manner. Before reviewing relevant literature, it must be
noted that a number of papers deal with related problems. In particular, some of
the literature on portfolio selection with transaction costs refers to liquidity;
the liquidity discount is then treated as a component of the total transaction
costs.432 Since this approach is not quite in line with the notion of liquidity as
a random result of a search process assumed in this work, this path of research is
not addressed here. Also approaches referring to portfolio structuring with random
cash demand are related to the problem of portfolio selection with illiquid
assets.433 Liquidity is defined there as the "need for cash", which is analogical
to the definition of "corporate liquidity" in Chapter 1 (see section 1.1.1.3).
Since the latter issue
432 433

See Pogue (1970), Constantinides (1986), or Grossman/Laroque (1990). See Chen et


al. (1972 and 1975) or Thakkar (1976).
278

Chapter 4: Liquidity as a Decision Criterion

has explicitly been excluded from the analysis, also this group of approaches
remains disregarded.

4.4.1.1. Asset Allocation with on-Tradable Assets


One of the first to discuss non-tradable assets in terms of capital assets pricing
was Mayers (1972).434 He modified the standard Capital Asset Pricing Model (CAPM)
to allow for assets that cannot be sold.435 Such assets, like human capital,
constitute a fixed part of an investment portfolio. Since they yield returns which
are not uncorrelated with the returns of marketable assets, a correction of the
capital pricing formula is necessary. Not only the systematic risk arising from the
(perfectly diversified) market portfolio has to be rewarded but also the risk of
the non-marketable asset, which cannot be diversified in the usual manner. The
following modified CAMP formula results:436 E(Ri) = RF + i*(E(RM) RF) with: = i
(4.13)

cov(R i , R M ) + ( PNM PM ) cov(R i , R NM ) V( R M ) + ( PNM PM ) cov(R i , R


NM )

RNM - returns of the non-marketable asset PNM/PM - relation of the value of all
non-marketable assets to the value of all marketable assets Brito (1977) further
develops this concept and formulates the "three fund separation theorem". According
to it, each market participant, apart from holding the (corrected) market portfolio
and the risk-free asset, which are identical for all investors, also holds a
corrective portfolio of marketable assets outbalancing ("diversifying") the effects
of the non-marketable one. The main conclusion from this approach is that
investors' liquid portfolios differ in equilibrium even when they are facing the
same universe of accessible liquid assets. Since each of them holds different non-
marketable assets, their corrective portfolios need to be designed individually.

434 435 436

See also Mayers (1973 and 1976) See also Elton et al. (2003), pp. 321-323. See
Mayers (1973), p. 266, and Elton et al. (2003), p. 322. Note, however, that the
correction of the Beta factor in the presence of non-marketable assets is highly
dependent on model assumptions. Stapleton/Subrahmanyam (1979) show for a range of
utility functions that the degree of marketability has no effect on the price of
risk or on the level of prices.
4.4 Portfolio Selection with Illiquid Assets

279

While the above discussed approaches consider the equilibrium state of a world with
non-marketable markets, Brito (1978) concentrates on portfolio decisions of
individual investors in this framework. He shows that rational capital allocation
decisions need to be made in a 3-dimensional room on the basis of the expected
returns and return volatilities of liquid (marketable) assets, and additionally on
the basis of correlations of these assets with the illiquid (non-marketable) one
(see Figure 4-19). However, in the presence of a risk-free interest rate (RR), the
decision problem can be reduced to two dimensions. For a given level of the liquid-
illiquid asset correlation (LIAC) it is optimal to choose the portfolio that
maximizes the reward-to-volatility (RV), i.e., the ratio of the expected return to
the return volatility; it is the portfolio X in Figure 4-19. Thus, the efficiency
criterion can be formulated on the basis of the RV-ratios and LIAC only. For an
individual investor, the choice of the optimal portfolio of liquid assets depends
on the RV-LIAC-efficient frontier and on the RV-LIAC-preferences.

Figure 4-19: Portfolio decision room with a non-marketable asset according to Brito
(1978)437

437

Modified after Brito (1978), p. 593. Symbols used in the original paper have been
changed to avoid confusion with other variables in the book.
280

Chapter 4: Liquidity as a Decision Criterion

Several other authors use analogical methods to analyze portfolio decision with
nontradable assets; among them are Svensson/Werner (1993), Henderson/Hobson (2002),
and Schwartz/Tebaldi (2006).

4.4.1.2. Models with Trade Restrictions


Approaches discussed in the former section, although a step in the right direction,
do not reflect the liquidity problem usually encountered in reality. Generally,
illiquid assets can be traded, but the trade is possible either with a delay or at
a discount. It is more realistic to assume that an illiquid asset purchased today
is restricted from selling only for a certain period of time. Selected works
following this idea are presented in this section. Longstaff (2001) analyzes a
continuous time model in which an investor divides her wealth between a risk-free
asset and a risky one. While the value of the first one is constant, the value of
the second one is random with stochastic volatility. The investor maximizes the
utility of her wealth. Since the volatility is not constant in this setting, the
optimal portfolio weight of the risky asset changes over time, so that it is
optimal to trade as frequently as possible. Liquidity is introduced by restricting
the number of shares of the risky asset that can be traded. In this situation, the
initial portfolio choice is of high significance as later adjustment possibilities
are limited. The effects of liquidity are modelled numerically. The analysis shows
that the optimal share of the risky asset is smaller when liquidity constrains are
introduced. The deviation from the unconstrained case (perfect liquidity) is larger
when the trading limit is smaller, when market volatility is less stable, and when
investor's time horizon is shorter. Longstaff also documents that trading
restrictions may lead to substantial value discounts of up to 80%.438 Kahl et al.
(2003) consider portfolio decisions in a three-asset universe.439 An investor can
allocate wealth in a risk-free bond or a risky stock market; both investments are
perfectly liquid. Apart from it, she is given a certain amount of an illiquid stock
at a time zero ("today"), which she cannot sell until some future point in time.
During this period, however, the illiquid stock can be traded by others, so that
its price, like the
438 439

See also Longstaff (1995). The model by Kahl et al. (2003) can be viewed as a more
general version of the model with nonmarketable assets by Henderson/Hobson (2002).
4.4 Portfolio Selection with Illiquid Assets

281

prices on the liquid stock market, follows Brownian motion. Furthermore, returns of
the liquid market and the illiquid stock are correlated, and the investor is
allowed to take unlimited short positions in all liquid investments. Her goal it to
choose the share of wealth invested in the liquid stock market and the level of
consumption that maximize her total (power law) utility. The optimal solution
depends on the assumed values of model parameters, in particular, on the level of
risk aversion, the volatilities of the risky assets, and the time horizon. The
correlation between the liquid stock market and the illiquid stock is of particular
importance in this setting; it can be expressed as the beta-coefficient of the
illiquid stock. High beta-values (either negative or positive) allow the investor
to hedge the risk of the illiquid stock by taking opposite, if necessary short,
positions in the stock index (see Figure 4-20). This result is in line with the
conclusions formulated in the literature on portfolio optimization with non-
marketable goods the inability to liquidate an asset, either permanent or
temporary, influences the selection of liquid assets, as this is the only way to
hedge risks that cannot be avoided by terminating the illiquid investment.
Furthermore, Kahl et al. illustrate on the basis of their model, how trade
restrictions can lead to substantial reductions of stock's values.440

Figure 4-20: Optimal portfolio weight of a liquid stock as a function of the


illiquid fraction for various levels of the illiquid stock's beta in the model of
Kahl et al. (2003)441

440

441

See also Silber (1991) for a study on discounts on restricted stocks and the impact
of illiquidity in this case. Kahl et al. (2003), p. 401.
282

Chapter 4: Liquidity as a Decision Criterion

The model of Longstaff (2004 and 2005) is a revised version of Kahl's et al. (2003)
model. Two players are assumed to be on the market: a patient one with a lower
discount rate, and an impatient one with a higher discount rate. These investors
can allocate capital between two assets: a liquid one and an illiquid one. Like
Kahl et al., Longstaff assumes that the illiquid asset cannot be traded for a
certain period of time; it experiences a trading "blackout". Both assets yield
dividends following geometric Brownian motions. Investors choose the shares of
their total wealth invested in each asset by maximizing their initial utility from
consumption. The main conclusion of the model is that portfolio structures change
substantially as soon as one of the assets is assumed to be illiquid. With an
increasing duration of the "blackout", investors give up diversification and change
to highly polarized portfolios; in particular, the impatient individual tends to
allocate nearly all of her capital in the liquid asset. On the basis of this model,
Longstaff illustrates how a temporary lack of marketability can lead to substantial
discounts on illiquid assets, even if they are otherwise identical with the liquid
ones. Further two models dealing with trade restrictions have been offered by Koren
and Szeild. Koren/Szeidl (2001), like Longstaff, assume an economy with two assets:
a liquid and an illiquid one. The liquid asset is instantly tradable at any point
in time but yields a lower rate of return; the illiquid asset can be bought at
anytime but selling it might be temporarily impossible due to the lack of buyers on
the market (buyers are assumed to arrive according to a Poisson process).
Furthermore, the investor experiences times of increased need for cash due to
randomly occurring alternative investment possibilities the inability to sell the
illiquid asset in this situation may result in the loss of a profitable investment
opportunity.442 The authors calibrated the model with reasonable parameter values
and analyzed the optimal (utility maximizing) portfolio choice of the investor.
They show that even a small increase in illiquidity, modelled through a lower
arrival rate of buyers and longer average marketing periods, can result in
substantial changes in the optimal portfolio allocation. For example, an increase
of the average waiting period from 3 to 5 days led to an increase of the share of
capital invested in the liquid asset by 4 to 6% points. Koren/Szeidl (2003)
consider a slightly altered framework in which the illiquid asset can be liquidated
only after a certain fixed lag from the moment of placing an order. The analysis of
the model leads
442

In this respect, the model by Koren and Szeidl resembles portfolio selection models
with stochastic cash demand; see Chen et al. (1972 and 1975) or Thakkar (1976).
4.4 Portfolio Selection with Illiquid Assets

283

to similar conclusions portions of capital invested in the liquid and illiquid


asset respond strongly even to slight changes in the grade of liquidity.
Additionally, a positive dependence between investor's risk aversion and the share
of wealth invested in the illiquid asset as well as between investor's impatience
(discounting factor) and the share of wealth invested in the liquid asset could be
stated; long horizon investors should hold larger shares of the illiquid asset.

4.4.1.3. Liquidity as an Independent Decision Criterion


Approaches presented above give interesting insights in the nature and the effects
of liquidity, but they are only of subordinate relevance for practitioners willing
to optimize their portfolios with respect to this factor. In fact, only very few
researchers address the subject of practical portfolio selection with imperfect
liquidity. Sharpe/Alexander (1990, p. 233-236) propose an extension of the CAPM to
allow for liquidity as an additional characteristic determining expected returns of
assets in efficient financial markets. They state that, like in the case of market
risk, only the marginal contribution of a security to the liquidity of an efficient
portfolio should affect expected returns. A security market plane rather than a
line would result from this modified version of CAPM. However, liquidity (defined
only briefly as the cost of selling or buying "in a hurry") is in this approach
only an example of an additional return-determining characteristic that modifies
the original CAPM in the direction of a multi-factor model like the one used in the
Arbitrage Pricing Theory (APT). Among the first to propose the inclusion of
liquidity as a separate decision criterion in the individual portfolio optimization
framework was Schmidt-von Rhein (1996, pp. 333-336). He regards liquidity as the
(relative) liquidation cost and suggests three methods how is can be implemented in
the MPT. The first one is to treat it as a separate random variable. This approach
is especially appropriate when the liquidation cost is uncertain and as such a
source of risk. Schmidt-von Rhein proposes to use its expected value and variance
as two additional decision parameters, but he notes that also other risk measures
can be applied. The main difficulty in this approach is the necessity to define a
multi-dimensional utility function that determines investor's preferences about the
trade-offs between the return-related and liquidity-related parameters. In view of
the expected practical problems, the author advocates for the use of simplified
methods. By assuming a constant liquidation cost, it is possible either to apply it
as an
284

Chapter 4: Liquidity as a Decision Criterion

independent decision variable in a three-parameter portfolio optimization, or to


subtract it from assets' returns and apply the standard two-parameter optimization
using net returns. Finally, the third possibility proposed by Schmidt-von Rhein is
to define a side constraint to the standard optimization algorithm requiring that
efficient portfolios have some minimum acceptable level of liquidity (maximum
liquidation cost). Lo et al. (2003) propose a method to introduce simple measures
of (public) market liquidity to the standard mean-variance portfolio optimization
approach; the idea is in its core similar to the approach proposed by Schmidt-von
Rhein (1996). A number of different measures can be used in this model, including
trading volume, turnover, or bid-ask spread. The authors define a very general
liquidity metric , which allows normalizing the (arbitrary) underlying liquidity
measure l . The metric for security i in month t is defined as follows: ~ ~ lit -
min lkT k ,T l it = ~ ~ max lkT - min lkT
k ,T k ,T

(4.14) - the maximal and the minimal value of the liquidity meas-

~ ~ with: max lkT , min lkT


k ,T k ,T

~ ure l computed over k securities in T months.


For portfolios, the respective liquidity metric is defined as the weighted average
metric of individual securities. Two further methods for measuring portfolio
liquidity are also proposed: one appropriate for the case when short sales are
allowed (absolute weights are used then), and one for the case when interactions or
cross-effects among securities with regard to their liquidity occur. Having defined
a portfolio liquidity metric, Lo et al. propose three ways to include it in the
portfolio decision process. Liquidity filters are used in the first approach.
Optimization techniques are only applied to portfolios with liquidity is greater
than some arbitrarily specified threshold level ( l 0 ). Efficient portfolios have
than a guaranteed minimum liquidity level, but they are not further differentiated
above this level. An alternative approach is to impose an additional side constrain
in the optimization problem. In this case, portfolios on the efficient frontier
have exactly the required level of liquidity. Finally, in the third approach,
liquidity is incorporated directly in the utility function. In this case, an
additional parameter needs to be employed to define the
4.4 Portfolio Selection with Illiquid Assets

285

weight placed on liquidity by the decision maker. Lo et al. assume a linear


preference with respect to the liquidity metric; different functional forms seem,
however, equally feasible. The three approaches are demonstrated in an empirical
example on the basis of selected US stocks. As illustrated in Figure 4-21, the
results vary depending on the method used. However, even the simplest liquidity-
based portfolio optimization procedure yields distinctly more liquid portfolio that
the standard MV-technique. The method proposed by Lo et al. (2003), though
undoubtedly improvable as noted by the authors themselves, is, to my best
knowledge, the only one of this kind to be found in the literature.

a)

b)

Figure 4-21: Examples of liquidity-filtered (a) and liquidity-constrained (b)


efficient portfolios according to Lo et al. (2003)443

Also the resent approach of Acharya/Pedersen (2005) is worth noting in the


discussed context although the issue of optimal portfolio selection is not directly
addressed there. The authors consider the influence of uncertain liquidity costs on
the pricing of capital investments. They assume that the liquidity discount is
random but correlated with the market-wide liquidity and with the returns of the
asset and the market portfolio. On this basis, they derive a liquidity-adjusted
version of the CAPM in which net returns after liquidity costs are considered.
According to this model, assets' expected excess returns are functions of the
systematic market risk and the systematic liquidity risk. Acharya and Pedersen
identify three types of liquidity risk associated with: (i) the commonality between
asset liquidity and market liquidity, (ii) sensitivity of asset re443

Lo et al. (2003), pp. 25 and 35.


286

Chapter 4: Liquidity as a Decision Criterion

turns to market liquidity, and (iii) sensitivity of asset liquidity to market


returns. The first type of liquidity risk results from the empirically stated fact
that there is a common factor affecting liquidity of securities on financial
markets;444 the second type of liquidity risk is the effect of investors'
preference for securities with higher returns in times when market liquid is low;
the source of the third type of liquidity risk is investors' readiness to pay
larger premiums for liquidity in times of low returns (i.e., in bull markets). In
the adjusted version of the CAPM, each of these risks is associated with a specific
Beta factor and priced separately. Though not explicitly stated by Acharya and
Pedersen, their approach implies that individual investors diversify their
portfolios not only with respect to market risk (on the basis of return
correlations) but also with respect to the three types of liquidity risk. The
latter can be diversified due to the commonality in liquidity, the relation between
securities' returns and market liquidity, and the relation between securities'
liquidity and marker returns. Thus, efficiency of assets needs to be considered
with respect to net returns, and the efficient frontier results from the
optimization with respect to all sources of risk. With a risk-free asset, which is
also free of any liquidity risk, the optimal portfolio corresponds with the
tangential line connecting the risk-free rate of return with the liquidity-adjusted
efficient frontier this line is described by the Acharya's and Pedersen's
liquidity-adjusted CAPM. 4.4.2. MPT with Illiquid Assets

The approaches presented in the preceding sections can be considered as steps in


the direction of the actual goal of this Chapter, i.e., the development of a
practicable method allowing rational portfolio decisions when investing in illiquid
assets. However, in view of the considerations about the nature of liquidity
conducted in earlier chapters, they do not seem to capture all aspects of the
problem. For instance, liquidity risk is to a large extent omitted in the model by
Lo et al. (2003) the measures employed by these authors focus mainly on the
expected liquidity. In contrast, Acharya/Pedersen (2005) disregard the possibility
that the investor could be forced into a premature liquidation of her portfolio.
Furthermore, practically all approaches concentrate only on liquidity of organized
public markets. The following two sections demonstrate how these problems can be
dealt with on the basis of the search theoretical approach. The
444

See Chordia et al. (2000 and 2005), Hasbrouck/Seppi (2001), or Huberman/Halka


(2001).
4.4 Portfolio Selection with Illiquid Assets

287

situation of a planned liquidation, which is in fact similar to the one considered


by Acharya/Pedersen (2005), is discussed first. The analysis of rational decisions
when an unexpected liquidation becomes necessary, which is somewhat related to the
approach of Lo et al. (2003), follows. In general, the considerations presented in
the following sections can be viewed as further development and application of the
ideas formulated by Schmidt-von Rhein (1996, pp. 331-336).

4.4.2.1. Planned Portfolio Liquidation


In the planned liquidation case the investor does not expect to sell any of the
assets in the portfolio before the assumed time horizon elapses, or she is simply
not concerned about such possibility. In this case, the liquidation problem arises
at the same moment as the realization of returns. Hence, returns are directly
affected by the outcome of the sale process. Due to this temporal coincidence,
there is no need to consider liquidation separately since the investor is only
interested on the total effective return, it is sufficient to concentrate on market
returns corrected for liquidation effects. The usual MV optimization techniques can
be applied for portfolio selection. The main problem in the considered case is the
determination of expected returns, return volatilities, and correlations that are
necessary to apply the portfolio optimization algorithm. Unlike in the case of
perfectly liquid investments, using historical market data will yield only biased
results for illiquid assets. This is because the historical returns, especially
when computed as average returns over multiple transactions, do not contain the
effects that result from the search for a trading partner. For illiquid assets
these effects may occur both at purchase and at sale. Pooled historical data or
market indexes provide information about average prices achieved by market
participants in the past; however, as demonstrated in Chapter 2, by searching
strategically, an individual may achieve (expected) purchase expenditures or sale
receipts differing from the average market valuation. Furthermore, each historical
transaction price or index value represents only one possible outcome of the random
search process. It is treated as known and certain from the ex post perspective,
but it is uncertain when viewed ex ante, i.e., before the search is accomplished.
Hence, the total uncertainty about the rate of return comprises of both the
uncertainty about the future market situation and the uncertainty about the
effective expenditures and receipts realized at the beginning and at the end of the
investment. Therefore, historical volatility underestimates the true volatility
experienced by the investor. In consequence, also correlations with other as-
288

Chapter 4: Liquidity as a Decision Criterion

sets are biased when based on historical data. The variability of the search
outcome superposes the variability of market values adding an additional source of
noise. Correlations between effectively realized returns are therefore lower than
correlations between market returns. In order to demonstrate how return statistics
can be corrected for search effects typical for illiquid assets, corrected
(effective) returns are denoted as R while index returns (or market returns) are
denoted as R. Furthermore, total index returns are split in the appreciation
component RApp and the income component RInc. For convenience, all considerations
refer to real estate. This allows the application of the real estate search model
and the formulation of an explicit solution; generalization on other classes of
illiquid investments is straightforward. Moreover, it is assumed that only purchase
and sale prices are affected by search effects; renting income is identical for all
market participants at all times. The starting point for the derivation of
corrected measures of expected returns, risks, and correlations for illiquid
property investments is the definition of the total return in period t:445
~

G - t -1 + CFt G CF ~ Rt = t = t + t -1 t -1 t -1 t -1
with: Et-1 Gt CFt - effective expense at purchase in period t-1. - effective sale
receipts in period t. - cash flow (net operating income) between t-1 and t.

(4.15)

Thus, the return from an investment is a compound effect of the random expense at
purchase (Et) and the random receipts from sale (Gt). In terms of the relative
search model, Et can be expressed as the average market valuation or the expected
offer E(P) multiplied with the relative expense t, and Gt is equal to E(P)
multiplied with the relative receipts t. Since both t and t are functions of the
respective reservation prices, so is the expected effective return in t:

445

The use of discrete instead of, otherwise standard, logarithmic returns is due to
computational problems arising in the latter case. The logarithmic return cannot be
presented as a sum of the appreciation return and the income return: this makes the
application of the search model to the appreciation component difficult.
4.4 Portfolio Selection with Illiquid Assets

289

G E (P t ) t CF CF t ~ E ( R t ) = E t + t - 1 = E E (P ) + E (P ) -
1 S, t , B, t -1 t -1 t -1 t -1 t -1 t -1 t -1 1 E(P t ) t CF t
= E S, t , B, t -1 + E (P ) E S,t , B,t -1 - 1 E (P t -1 ) t -1 t -1
t -1

(4.16)

Note that the ratio of the average price level in t to the average price level in
t-1 corresponds with the index-based appreciation return, and the ratio of the
operating income to the average price level in t-1 corresponds with the index-based
income return. Substituting for these variables and omitting the reservation
prices' conditions for better tractability yields: 1 ~ E(R t ) = (1 + R
App,t ) E t + R Inc,t E -1 t -1 t -1 (4.17)

It is apparent from this presentation that not only the appreciation return but
also the income return needs to be adjusted. Assuming that in the typical case the
search for the best seller leads to a purchasing expense below the average market
level (and thus below E(P)) and the search for the best buyer leads to sale
receipts above the average market level, both components of the effective return
are higher than those assessed on the basis of average market prices. The expected
effective return over the whole time horizon is estimated as the average return
from all periods:
1 1 N ~ E (R ) = (1 + R App, t ) E t + R Inc, t E - 1 N t =1
t -1 t -1

(4.18)

The adjustments of further statistics are done in an analogical manner. The


variance of the effective return is composed of the fluctuations of the index
return and of the fluctuations of the expenditures/receipts realized at
purchase/sale:
290
~ ~ ~ V(R ) = E(R 2 ) - E 2 (R ) =

Chapter 4: Liquidity as a Decision Criterion


N 1 N 1 ~ ~ E(R 2 ) - E 2 (R ) = t N -1 N -1 N - 1 t =1

N 1 t2 2 (1 + R App,t ) 2 E 2 + R Inc,t E 2 + 2 (1 + R App,t ) R


Inc,t E 2t t =1 t -1 t -1 t -1

(4.19)

1 N 2 ~ - 2 (1 + R App,t ) E t - 2 R Inc,t E + 1 - N - 1 E (R )
t -1 t -1 Finally, following the same reasoning, the correlation coefficient
between the effective returns of two illiquid assets can be defined as follows: ~ ~
~ ~ ~ ~ cov(R A , R B ) = E(R A R B ) - E(R A ) E(R B ) = =
N 1 N ~ ~ ~ ~ E ( R A , t R B,t ) - E (R A ) E(R B ) N - 1 t =1 N -1 N 1
(1 + R App,A ,t ) (1 + R App,B,t ) E A ,t B,t B,t -1 N - 1 t =1 A ,t -1

A ,t + (1 + R App,A ,t ) R Inc,B,t E B,t -1 A ,t -1 B,t - (1 + R


App,A ,t ) E A ,t + (1 + R App,B,t ) R Inc,A ,t E B,t -1 A ,t -1 A ,t
-1 1 - (1 + R App,B,t ) E B,t - R Inc,A ,t E A ,t -1 B,t -1 1
1 + 1 + R Inc,A ,t R Inc,B,t E - R Inc,B,t E B,t -1 A ,t -1 B,t -1
N ~ ~ - E(R A ) E(R B ) N -1

(4.20)

All of the above formulas contain the ratio of the relative sale receipts to the
relative purchase expense under the expectation operator, what makes them
analytically unsolvable. However, an approximation is possible using a Taylor
series representation of the expected value and the variance of a quotient of two
random variables provided by Mood et al. (1974, p. 181). Limiting the series to the
first three terms, what should be sufficient for most practical applications,
yields the following formulas:
4.4 Portfolio Selection with Illiquid Assets

291 (4.21)

E ( ) cov(, ) E () V ( ) - + E E 2 ( ) E 3 ( ) E ( )
V ( ) cov( , ) E ( ) V ( ) V E ( ) E 2 ( ) + E 2 ( ) + 2 E ( ) E
( )
2

(4.22)

These formulas can be easily rearranged to provide estimations for the problematic
terms in the equations (4.18), (4.19), and (4.20). The complexity of the above
problem can be substantially reduced by slightly redefining the decision framework.
The assumption that both the purchase price and the sale price are random
corresponds with decision making in terms of abstract asset classes. In other
words, the investor makes the decision of allocating capital in a certain asset
class (a real estate submarket) before starting to search for concrete
opportunities within this class. However, in practice, decisions are often made on
the basis of concrete investment opportunities. After receiving a proposition of
buying an investment at a certain price, the investor considers the effect of such
a purchase for her portfolio and makes the decision on the basis of these
considerations. In this framework, the purchasing expense is not random at the
moment of decision making it is known and can be expressed either in absolute
units or as a fraction of the current average market valuation. The latter one can
either be objective (i.e., based on perfect knowledge of the market) or subjective
(i.e., resulting from investor's personal market assessment). Only the exit side of
the investment (i.e., the future sale receipts) is affected by uncertainty in this
situation. If the relation of the initial purchase price to the average market
valuation is denoted as , the expected return, volatility, and the covariance of
the effective return can be redefined as follows: R 1 N (1 + R App,t ) ~ E( t )
+ Inc,t - 1 E(R ) = N t =1 (4.23)

~ V(R ) =
2 N ( + R 1 (1 + R App,t ) R Inc,t R2 1 App ,t ) E(t ) (4.24) V(t ) + E 2 (t ) +
Inc,t + 2 2 N - 1 t =1 2 2

- 2

(1 + R App,t )

E(t ) - 2

R Inc,t N ~ + 1 - E 2 (R ) N -1
292

Chapter 4: Liquidity as a Decision Criterion

~ ~ cov(R A , R B ) = + - -
N (1 + R 1 App ,A , t ) (1 + R App,B, t ) (cov(A ,t B,t ) + E(A ,t ) E(B,t ) )
N - 1 t =1 A B

(1 + R App,A ,t ) A B (1 + R App,A ,t ) A R Inc,B,t B +

R Inc,B,t E(A ,t ) + E(A ,t ) -

(1 + R App,B,t ) R Inc,A ,t A B E(B,t ) - A

E(B,t )

(4.25)

(1 + R App,B,t ) B

R Inc,A ,t

R Inc,A ,t R Inc,B,t A B

N ~ ~ + 1 - E(R A ) E(R B ) N -1

Since analytical formulas for all expressions in the above equations are available
(see sections 2.3.2, 3.3.2, and 4.2.3.2), a quick and efficient computation is
possible. In the considered case of a planned liquidation, return statistics are
adjusted on the basis of concrete search strategies, which the investor plans to
apply when purchasing and liquidating the asset. This means that the corrected
expected returns, return volatilities, and correlations are valid only for the
assumed set of strategies. Since the choice of the strategy depends on investor's
preferences, the resulting return statistics are only valid for the concrete
investor. Thus, no objectively optimal portfolio can be designed.

4.4.2.2. Unexpected Portfolio Liquidation


As discussed in section 1.4.2.2 in Chapter 1, illiquidity is problematic not only
because of possible difficulties when purchasing and selling an asset according to
the assumed investment strategy, but also, or even mainly, because of the
impossibility of a quick liquidation in an emergency case. An investor experiencing
unexpected liquidity problems and forced to sell a part of her investment portfolio
in order to settle due payments is therefore usually better off using liquid rather
than illiquid assets for this purpose. However, there are still strong arguments
for investing in real estate and other illiquid assets these include mainly
advantageous risk-return profiles as well as contributions to the overall portfolio
diversification. Thus, a rational portfolio selection strategy should consider the
trade-off between the possibility of a quick liquidation without incurring major
discounts and the advantages resulting from including an illiquid asset in the
portfolio.
4.4 Portfolio Selection with Illiquid Assets

293

The conclusions from the previous section still hold in this case. Expected
returns, volatilities, and correlations of illiquid assets computed on the basis of
average prices or indexes always contain biases resulting from the omission of
search effects at the end of the time horizon. Thus, return parameters need to be
adjusted in any case. However, even corrected returns are only valid when assets
are held until the end of the planned investment horizon. Should an unexpected,
premature liquidation be necessary, none of the computed statistics will hold. In
such cases, the possibility of a favorable sale of a single asset or the whole
portfolio at any time becomes relevant. Although the nature of the search problem
is generally the same independent of the moment of the liquidation, the receipts
from a premature sale cannot be combined with market returns due to the lack of
time coincidence. This makes it necessary to consider asset liquidity in the case
of an unexpected liquidation as a separate decision criterion in addition to the
expected return and market volatility.446 The main practical problem when modeling
an unexpected sale using a search model is the unknown liquidation time and,
consequently, the unpredictable state of the market at this moment. While a
forecast can be used in the analysis of a planned liquidation, this approach is
rather inapplicable when no date can be defined to which the forecast would refer.
Thus, the best available solution is to fall back on the relative search model
discussed in section 2.3.1.6. By defining offers in reference to the current market
price level, the influence of the market state (i.e., the average level of offers)
is neutralized. Provided that other model parameters including the dispersion of
offers, offer arrival frequency, and market trend remain stable, the results should
be valid throughout the whole investment period. Furthermore, one should consider
that investor's time preference is different when the sale is due to unexpected
liquidity problems than in the case of a planned and expected liquidation. Since
the main priority is then to sell quickly, the investor calculates with a higher
discounting rate. In its principles, the portfolio selection framework allowing for
liquidity in terms of an unexpected sale is not very different from the "common"
MPT selection framework. Like in the traditional method, the selection process can
be split into two steps: identification of objectively efficient alternatives and
choice of the alternative subjectively preferred by the investor. The only
difference to the MPT is the larger number of decision variables. It leads,
however, to difficulties with the application of existing optimi446

See Schmidt-von Rhein (1996), p. 333.


294

Chapter 4: Liquidity as a Decision Criterion

zation tools. With respect to the efficiency principle, both the stochastic
dominance and the parametric approach can be followed. According to the first
degree stochastic dominance (FSD) criterion applied to market returns, one
investment alternative dominates another alternative if for any return level the
cumulative probability of achieving it is higher for the first alternative than for
the second one. In this sense, efficient are only those alternatives which are not
dominated by any other. Referring to asset liquidation, the FSD criterion defines
an efficient strategy as the one for which no other strategy exists that would
allow achieving any level of net sale receipts with a higher cumulative probability
than the considered strategy. By combining these two definitions, a two-dimensional
stochastic dominance criterion can be formulated: one investment alternative
dominates another alternative if any combination of market returns and (relative)
net sale receipts can be achieved with a higher cumulative probability for the
first alternative than for the second one. The respective cumulative probability
functions can be represented graphically as plains assigning each combination of
returns and liquidation receipts the probability of its occurrence. Thus, one asset
dominates another asset if the plain characteristic for the first one lies entirely
above the plain characteristic for the second one. In this sense, asset X in Figure
4-22 dominates Y, but asset Z is not dominated by any other. In consequence, X and
Z are efficient, and Y is inefficient.
4.4 Portfolio Selection with Illiquid Assets

295

Cumulative probability

X Y Z

Ne t sa le r ec e ipts

t rke Ma

rn retu

Figure 4-22: Stochastic dominance with return and liquidity goals

As already discussed, the main problem with stochastic dominance is the required
knowledge of the whole probability function, which is usually very difficult if at
all possible to determine. Parametric approaches concentrating only on selected
parameters of the probability distribution are therefore easier in application
though less general.447 Expected returns and return volatilities are used in the
Markowitz's portfolio selection model. The simplest way to allow for liquidity in
this framework is to extent the set of decision variables by an additional variable
referring to assets' and portfolios' liquidity, as was done by Lo et al. (2003).
The key issue in this approach is the choice of the adequate liquidity measure. As
already discussed in Chapter 3, no single measure can fully capture all aspects of
this problem. Therefore, any single measure can be only a "second best" solution.
It seems that measures combining several aspects of the problem are best suitable
for this purpose. Among them are the utility based measures as well as the
performance measures. Since the first group requires the as447

For analogical considerations see Schmidt-von Rhein (1996), S. 333-334.


296

Chapter 4: Liquidity as a Decision Criterion

sumption of a specific utility function, it is rather difficult to apply in a


general model. Liquidity performance measures have the advantage of being
objective, independent of investors' individual preferences. Among them, the
Liquidity Risk Reward is an especially appealing candidate for a decision variable.
Due to its interpretation as the slope of the efficient line in the strategic
liquidation of an illiquid asset together with a liquid one, it is a good measure
of objective liquidity understood as the possibility of efficient liquidation.448
LRR is therefore used in the following considerations. The course of reasoning
would, however, be the same if other measures were applied instead. The general
principle of portfolio selection based on three decision variables is the same as
in the traditional model.449 Efficient alternatives are identified first, and the
optimal one is chosen from among them on the basis of investor's individual
preferences. The definition of an efficient portfolio is slightly modified and
encompasses its LRR a portfolio is efficient when no other portfolio exists
having simultaneously a higher expected return, lower return volatility, and higher
liquidity. Portfolios can be presented graphically as points corresponding with
respective combinations of E(R), S(R), and LRR the efficient ones form the
efficient plain as presented in Figure 4-23. Since investor's utility also needs to
be defined with respect to all three variables, the levels of constant utility can
be presented as indifference planes. The optimal portfolio results as the
tangential point of the efficient plane and the highest possible indifference plane
it is the portfolio that maximizes investor's utility with respect to all three
decision variables.

448 449

See sections 3.4.1 and 4.3.2. Introduction of additional dimensions in the


portfolio optimization problem is not new. Probably most discussed was the
enhancement of the decision rule with further moments of the return distribution,
especially the skewness; see, e.g., Samuelson (1970), Konno/Yamamoto (1993, 2005),
Liu et al. (2003), or Fss (2004), pp. 374-410, and the literature cited there..
Also other goal variables are considered, e.g., the "ethicalness" of investments
(see Beal et al., 2005).
4.4 Portfolio Selection with Illiquid Assets
Retu rn

297

Vola tility

Expe Expected Return

Utility Indifference Planes Efficient Plane Optimal Portfolio


id Liqu

0
RR) ity (L

Figure 4-23: Efficient plane and portfolio selection with a one-dimensional


liquidity goal

In the above three dimensional asset selection framework only illiquid portfolios
having positive LRR values can be considered. Note that no perfectly liquid
portfolios can be analyzed explicitly in this framework because the liquidity
reward measure is not defined in such cases both the numerator and the
denominator of the LRR ratio are then zero. However, this does not mean that liquid
assets are generally excluded from the analysis. As demonstrated in section 4.3.2,
LRR is a good measure of liquidity especially in the case of a simultaneous sale of
illiquid and perfectly liquid assets. It can be then interpreted as the marginal
expected reward for accepting liquidity risk. Thus, the application of LRR implies
that the investor considers selling both liquid and illiquid assets and is
concerned about the optimality of the liquidation strategy in such case.
Nevertheless, the impossibility of analyzing purely liquid portfolios and comparing
them with illiquid ones is a serious limitation of this approach. Therefore, it
seems to be useful only to those investors who definitely have illiquid assets in
their portfolios and decide only about their optimal combination. Among others,
most real estate funds and companies belong to this group.
298

Chapter 4: Liquidity as a Decision Criterion

Using other liquidity measures, which assume finite values for liquid assets, may
provide a solution to the above problem. However, new difficulties are likely to
arise due to the general limitations of one-dimensional liquidity measurement as
discussed in Chapter 3. Thus, three-dimensional optimization can only yield proper
results in certain cases, especially when no perfectly liquid portfolios are
allowed, or when the investor is not concerned about certain aspects of liquidity,
e.g., liquidity risk. To allow for a more general approach, the concept of
strategic asset liquidation presented earlier in this Chapter can be fully
integrated in the traditional MPT framework. Combining these two approaches
requires that the set of decision variables includes measures of expected
liquidation outcome and liquidity risk in addition to the expected return and
return volatility. Expected net sale receipts and receipts' volatility can be used
here, so that portfolio decisions are made on the basis of four variables: E(R),
S(R), E(), and S().450 Assuming that all rational investors prefer higher expected
returns and higher expected net sale receipts to lower ones and prefer lower risks
to higher ones allows defining the set of efficient alternatives. An efficient
portfolio is in this context the one for which no other portfolio exists having
simultaneously a higher expected return, higher expected sale receipts, lower
return volatility, and lower receipts' volatility. Due to the large number of
variables, it is not possible to represent the so defined efficiency principle
graphically. One can, however, imagine a four dimensional space in which each
portfolio can be represented as a point corresponding with the respective
combination of the four decision parameters. Efficient portfolios form a
fourdimensional hyperplane, which is analogous to the efficient frontier in the
standard model. Rational investors should choose only portfolios lying on the
efficient hyperplane. Selection of a concrete portfolio requires the definition of
a utility function, which also needs to be extended by two additional variables:
E() and S(). The indifference hyperplane consisting of combinations of the decision
parameters leading to the same utility level is therefore also four-dimensional.
The optimal portfolio corresponds with the single tangential point of the highest
possible indifference hyperplane and the efficient hyperplane.

450

This approach corresponds with the proposition of Schmidt-von Rhein (1996), p. 333.
Of course, other measures of liquidity risk can be used. In particular, it is
possible to apply asymmetric measures defined in section 3.3.3.
4.4 Portfolio Selection with Illiquid Assets

299

An advantage of this approach is the possibility of analyzing any combination of


any assets. For portfolios consisting only of perfectly liquid ones, relative
expected sale receipts are equal to 1 and receipts' volatility is zero; thus, they
are all located on a two-dimensional E(R)-S(R)-plane and correspond with the
"liquid" efficient frontier. On the other hand, illiquid assets have S() values
higher than zero; they should also have E() values higher than one as strategic
choice of the reservation price should generally lead to higher receipts than using
no strategy at all. Furthermore, if any arbitrary combination of liquid and
illiquid assets can be liquidated, the corresponding graphical representation is a
line connecting the "liquid" and "illiquid" points. A "flat" efficient hyperplane,
analogical to the efficient line in the traditional MPT, results. The four-
dimensional approach to portfolio selection is in line with the liquidity
definition formulated in Chapter 1. It is very general and allows identifying
efficient portfolios for all assets for which parameters of the search model can be
assessed with sufficient accuracy. In particular, it allows an adequate analysis of
portfolios containing direct real estate investments when the real estate search
model is applied. The elimination of the limitations of the traditional MPT arising
from the assumption of perfect liquidity of all assets is, however, achieved at the
cost of increased model complexity. The lack of analytical solutions and the
necessity of extensive numerical computations, high grade of mathematical
complexity, and the impossibility of a graphical presentation of the outputs may
make the intuitive tractability of the results difficult and, in effect, negatively
affect the acceptance of the model. It seems that in many cases it is sufficient to
use only one liquidity measure (e.g., LRR). Hence, the decision to use the full,
four-dimensional model is, as in all cases of practical application of theoretical
concepts, a trade-off between easy tractability, low-cost implementation, and
adequate modeling of reality. 4.4.3. Optimization Algorithms

From practitioners' point of view, the possibility of a quick and effective


determination of efficient portfolios is of key importance. A number of
optimization algorithms allowing automated computation on the basis of easily
accessible market data are available for the original MPT model. The Critical Lines
Algorithm (CLA) is probably the most popular portfolio selection tool, but also
alternative techniques applicable to
300

Chapter 4: Liquidity as a Decision Criterion

different variations of the decision problem have been developed.451 They are
usually based on quadratic programming and allow determining the composition of
assets leading to the lowest possible volatility of portfolio returns at a given
level of expected returns. Unfortunately, they are not directly applicable to the
modified version of the model presented in the former section. The decision problem
behind the efficient hyperplane can be formally formulated as follows:452, 453
Minimize: V(R P ) = w i2 V(R i p ,i ) + w i w j Cov(R i , R j p ,i , p , j ) E
E E
i =1 i =1 j=1 ji N N N

(4.26)

subject to constraints:
E(R P ) = w i E(R i p ,i ) E
i =1 N

E(P ) = w i E(i p ,i ) UE
i =1 N

V(P ) = w i2 V(i p ,i ) + w i w j Cov(i , j p ,i , p , j ) UE UE UE


i =1 i =1 j=1 ji

wi = 1
i =1

with: p ,i E
p ,i UE

- reservation price applied in the planned liquidation of asset i - reservation


price applied in the unexpected liquidation of asset i

Thus, the investor seeks a portfolio that allows her to achieve a minimal variance
of returns at a given levels of expected returns, expected net sale receipts, and
receipts' variance. Alternatively, other parameters can be optimized; e.g., the
variance of liquidation receipts can be minimized for given levels of the remaining
three parameters.

451 452

453

For a review of portfolio optimization techniques see Rudolf (1994). This


formulation is analogical to the standard one used in the traditional MPT. See,
e.g., Levy/Sarnat (1984), pp. 341 f. The constraint requiring nonnegative share of
each asset is often added; however, it is not necessary if short sales are allowed.
Strategic purchase of assets is omitted for better tractability.
4.4 Portfolio Selection with Illiquid Assets

301

Since the result is the same in each case, the choice of the optimization scheme is
only the question of computational convenience. Independent of the optimization
approach, the goal is to find a combination of strategic variables that leads to an
efficient portfolio. However, while assets' weights are the only variables in the
original MPT, two additional variables for each asset need to be determined in the
extended model: relative reservation prices applied in the case of a planned
liquidation, and reservation prices applied in the case of an unexpected
liquidation. They can but don't necessarily need to be identical. In fact, since
the time preference is usually different in these cases, it seems more likely that
different liquidation strategies, and thus different reservation prices, are
optimal. In effect, with N available investments the number of strategic parameters
increases from (N-1) in the original portfolio selection framework to (3N-1) in the
modified framework with strategic liquidation. This makes the optimization formula
incomparably more complex. In particular, the analytical insolvability of the
equations describing statistical parameters of sale receipts with respect to
reservation prices (formulas 2.38, 3.28, and 4.7) results in the unavailability of
a closed form solution for the optimal portfolio. In consequence, neither quadratic
optimization used in the original portfolio selection model nor any other known
technique can be applied to find a portfolio corresponding with a concrete
combination of the decision criteria. Numerical approximations or Monte Carlo
Simulations seem to be the only available methods. Summing up, there seems to be no
straightforward method allowing a quick, effective, and precise identification of
the efficient frontier when illiquid assets are included in the portfolio without
sacrificing at least some of the key elements of the model developed in Chapter 2.
However, in many cases the number of possible portfolios is limited. Since many
illiquid assets have high unit values and are indivisible or divisible only with
substantial difficulties, they are very often available only in large lumps. This
applies especially to real estate but also to arts and many private equity
investments. Hence, with limited funds at investors' disposal, the share of
illiquid assets of different types in the portfolio cannot be set at any arbitrary
level. In consequence, only a limited number of asset combinations, and thus a
limited number of feasible portfolios, are possible. Limiting the analysis only to
realistic scenarios substantially reduces the range of numerical computations
necessary for the estimation of the efficient hyperplane. The computational effort
can be further reduced by introducing side
302

Chapter 4: Liquidity as a Decision Criterion

constraints. This especially refers to the reservation prices. As demonstrated


earlier in this Chapter, only a relatively narrow range of *-values leads to
efficient combinations of expected receipts and receipts' volatilities. Reviewing
reasonable ranges for each asset before running the optimization should help to
keep the size of the simulation within reasonable limits. Thus, it should be
possible to accomplish the analysis at a satisfactory precision level using a
common personal computer in many practically relevant cases. 4.4.4. Sources of
Biases

Like all models that simplify reality, also the approach presented in this Chapter
has its weak points. Some of the problems resulting from the assumptions made in
the search theoretical model have been already discussed in section 2.3.3. On the
other hand, the limitations of the MPT have been the subject of section 4.1.4.
Obviously, they also apply to any investment decision framework building on these
models. Although many of them can be solved or at least mitigated, some of them are
still unavoidable. Identifying them is especially important for practitioners the
decision maker should be aware of the direction of possible biases that may result
from the application of the model. Two possible sources of biases, which seem to
play the largest role, are discussed in this section: those resulting from the
assumptions met during the construction of the search model, and those resulting
from the choice of volatility as the risk measure.

4.4.4.1. Effects of Search Model Imperfections


The way in which correlations between sale receipts are computed in the search
theoretical model is one of the main sources of biases in the composition of
portfolios optimized on the basis of this model. This issue has already been
discussed in section 4.2.3.2. The fact that market uncertainty factors (A) for
different assets refer to possibly different durations of search makes their
assessment on the basis of correlations between empirically observed prices or
returns disputable. Unless average search durations are similar for both assets,
this approach leads to a possibly substantial overestimation of the true receipts'
correlations, what may distort the optimal portfolio composition in several ways.
Firstly, the volatility of portfolio liquidation receipts might be falsely
estimated since the actual liquidity diversification effect is either larger (when
the affected correlation is positive) or smaller (when the correlations is
negative) than
4.4 Portfolio Selection with Illiquid Assets

303

assumed. Secondly, the volatility of portfolio returns may also be biased due to an
incorrect correction of market returns for search effects in the case of a planned
liquidation at the end of the time horizon. In effect, the method may tend to
assess the quality of portfolios with large stakes of illiquid assets too
pessimistically or too optimistically depending on the direction of the correlation
between assets. Another problem related to the way market changes are incorporated
in the model is its incompatibility with the random walk thesis (see section
2.3.1.5). This is not quite in line with the traditional portfolio theory, which
requires that asset returns follow random walk. Since the search model is
unsolvable if randomness in continuous returns is assumed, some inconsistency of
the modified portfolio selection approach is unavoidable. The direction of the
resulting bias is difficult to assess in this case. Simulations indicate that both
the expected receipts and the volatility of receipts might be slightly lower if
normal and not lognormal distribution of changes in the market price level is
applied. In consequence, the model may suggest a slightly lower weight of illiquid
assets in the optimal portfolio than actually justified. However, the difference
should not be significant and of marginal practical relevance. The assumed
equivalence between the average valuation of potential buyers, the average value of
offers, and the presumable market price of the asset if it was liquid may also
prove problematic. Obviously, as discussed in section 2.4, no perfect equivalence
of this type is to be expected. When not all market traders are assumed to be nave
and at least some of them behave strategically, the observed transaction prices
(and the hypothetical market price) should tend to be higher than the average of
bids received by sellers and lower than the average of offers received by buyers.
This misspecification can lead to an overestimation of the receipts from
liquidation and possibly to a too high share of illiquid assets in the optimal
portfolio. The deviation of the real bidding system from the one assumed in the
model may have a similar effect. In particular, the existence of listing prices in
most real estate markets should lead to lower sale receipts and higher purchase
expenditures compared to the situation when investors do not reveal their
preferences and decide only on incoming offers. The model might suggest a too high
share of real estate in the optimal portfolio in this situation. Constant grade of
time preference during the search is a further feature of the search model that may
lead to biased results. As already discussed in section 2.3.1.3, the discounting
rate will most probably increase as the asset remains unsold over a longer
304

Chapter 4: Liquidity as a Decision Criterion

period of time. By ignoring the changes in the time preference, the (real estate)
search model overestimates the gains from searching. Especially in the case of a
forced liquidation, which is particularly relevant in the portfolio selection
approach, a constant and certain discount rate is not quite realistic. Optimally,
it should reflect the level of delay costs expected in such case. However, since
the reason for the unexpected sale is unknown ex ante, also the appropriate
discounting factor is uncertain. Ignoring this source of uncertainty in the model
leads to an underestimation of the receipts' volatility. The consequence might be a
too high portion of illiquid assets in the portfolio.

4.4.4.2. Risk Measurement Issues


Sources of biases may also lie in the statistics used as decision variables. This
refers especially to the measures of market and liquidity risk. This issue has been
already referred to in section 3.3.3. However, due to its relevance for the
portfolio selection problem, it is necessary to stress the effects of using
volatility (variance) in this context. As discussed in section 3.3.3.1, volatility
is an adequate risk measure if either the investors understand risk as any
deviation from the desired or expected outcome or if the risk variable is normally
or at least symmetrically distributed. The first case seems to be an exception
rather than a rule most investors fear that the realized market returns and sale
receipts could turn out to be lower than expected, but they would have nothing
against unexpectedly high returns or receipts. Only seldom both too high and too
low outcomes are regarded as negative. Also the shapes of the return and receipts
distributions are problematic. While normal distribution of market returns is
disputable for publicly traded stocks,454 it has to be clearly rejected for many
other assets including real estate.455 Also the distribution of net sale receipts
or purchase expenses is rarely normal (see sections 2.3.4 and 3.3.3.1). The
deviation from normality is higher when the difference between the discounting
rate, market's growth rate, and offer arrival frequency is larger. Hence,
especially in the case of an unexpected liquidation, in which the investor is under
a high time pressure and calculates with a higher discount rate, non-normally
distributed receipts can be expected. Moreover, simulations show that they tend to
be right-skewed.
454 455

See references in FN 230. See references in FN 231.


4.4 Portfolio Selection with Illiquid Assets

305

The above mentioned problems lead to the lack of conformity between the measured
risk and the risk actually experienced by the investor.456 In consequence,
optimization techniques lead to portfolios that are formally efficient but with
respect to wrong goals. If the true probability distribution of market returns is
left-skewed, variance underestimates risk, and with a right-skewed return
distribution, risk is overestimated (see Figure 3-3). In effect, seemingly
efficient portfolios contain too much or too little of the affected asset,
respectively. Same holds for liquidation receipts. However, since in the most
relevant case of a forced liquidation, the receipts' distribution tends to be
right-skewed due to the high discounting rate, variance can be expected to
underestimate liquidity risk leading, in consequence, to a too high share of
illiquid assets. The best solution to the above problem would be to replace
variance with an asymmetric measure. This issue is well researched with respect to
portfolio selection with liquid assets. Return volatility is usually substituted
with semi-volatility or other lower partial moment. An alternative approach is the
introduction of skewness as an additional (third) decision parameter.457
Analogically, asymmetric measures of liquidity risk discussed in section 3.3.3 can
be used instead of volatility, or receipts' skewness can be introduced; however,
respective formulas or computation algorithms would need to be derived in both
cases, what may prove difficult. Furthermore, including skewness as an additional
parameter would substantially increase the number of decision variables and
additionally complicate the portfolio selection process with three return-related
and three liquidity-related parameters, the decision room would become six-
dimensional. Summing up, there are a number of reasons why a portfolio selection
model with illiquid assets based on the search theory, and especially on the real
estate search model, may yield biased and, in effect, suboptimal (at least
partially) results. Most of the above discussed problems lead to a too high portion
of illiquid assets. The extent of the distortions depends mainly on the discrepancy
between the features of the market on which the investor is active and the
assumptions of the model. While the application of the model to portfolios
containing real estate should be possible with no or only slight errors, the
inclusion of other illiquid assets can be highly problematic. In any case, a
456

457

There is a large amount of literature on the consequences of the incompatibility of


variance as a risk measure for portfolio selection; see Ortobelli et al. (2005) for
a review. See literature references in FN 449. There also exist approaches
introducing higher moments (e.g., kurtosis) to the decision framework; see Breuer
et al. (1999), pp. 177-217, for a review.
306

Chapter 4: Liquidity as a Decision Criterion

detailed analysis of the grade to which model assumptions are fulfilled is


necessary. Even then, however, some inaccuracies will be unavoidable; they are
immanent to any theoretical approach that attempts to simplify reality. The
question is therefore, how large errors are still acceptable. For more accurate
results, one can attempt to develop a more realistic version of the search model,
e.g., by implementing the propositions made in section 2.3.3. This, however, would
lead to a substantial increase in the complexity of the approach. Thus, there is no
easy solution to the trade-off between practicability and realism. *** Methods
presented in this Chapter were intended to offer practicable tools allowing
rational decisions on illiquid assets. The main innovation is the merger of the
traditional mean-variance optimization framework with the search theoretical
approach. This way, the advantages of search models in the analysis of illiquid
assets can be implemented in the probably most popular decision technique allowing
the optimization of the liquidation processes on the one hand, and the optimization
of portfolios containing illiquid investments on the other hand. The price for the
broader scope of application is, however, the high level of complexity. With the
larger number of decision criteria and additional strategic variables, no simple
optimization method can be applied. An analytical solution to the problem is also
not in sight leaving numerical approximations and simulation techniques as the only
possibility. Nevertheless, it seems that in many cases, especially in the analysis
of direct real estate investments, these limitations can be overcome. The results,
though not of point precision, should be acceptable for practitioners and in any
case preferable to the results achieved with methods that ignore liquidity
considerations. The next chapter offers a practical demonstration how these methods
can be applied to real estate investment decisions.
Chapter 5 Liquidity of German Condominium Markets

A number of techniques for dealing with low levels of liquidity of privately traded
assets, in particular real estate, have been developed in the previous chapters.
They are based on the model of search for a trading partner, which allows a formal
analysis of the selling or purchasing process and the resulting net receipts or
expenses. Large parts of the discussion focused on the derivation of closed form
solutions that could be applied in practice using data available to investors.
However, most of the hitherto considerations were only theoretical. It is possible,
and even probable, that in the course of their practical application to concrete
problems obstacles occur that have not yet been addressed. This Chapter is intended
to uncover and discuss some of such obstacles and to demonstrate possible ways of
dealing with them. This is done by applying the search theoretical methodology to
analyze liquidity of residential condominiums in selected German urban areas. This
exemplary application should be viewed as a step toward the practical
implementation of the concepts developed in this book. The main problem with the
application of the search theoretical approach to real estate liquidity is the
determination of the model parameters. Although it is relatively easy to define
variables such as the "divergence of valuations" or the "frequency of offer
arrivals" on the abstract level, it may be extremely difficult to assign them
concrete values when addressing a specific real estate market. This issue is
discussed in the first section of the Chapter. Further sections demonstrate the
implementation of the model on German residential real estate markets. The data is
presented in the second section it consists mainly of large samples of
transaction prices for residential condominiums in selected large German cities.
The third section is devoted to the comparison of liquidity levels of the analyzed
markets using different approaches from Chapter 3. The fourth section utilized the
methods developed in Chapter 4 to derive optimal liquidation strategies as well as
optimal portfolio decisions with respect to investments in the analyzed markets.
Finally, the last section summarizes the main findings and offers a critical
discussion of the methods.
308

Chapter 5: Liquidity of German Condominium Markets

5.1.

Determination of Model Parameters

Since all liquidity measurement and liquidity management methods presented in this
book are based on the search model, their application depends on the ability to
determine the parameters of the underlying model. While some of them are relatively
straightforward, other are not directly observable and need to be derived
implicitly from the available data. The latter, by their nature, are always more or
less approximate, what results in errors affecting the quality of the decisions
made on the basis of the model. This problem is, however, immanent to any methods
attempting to capture complex processes within simplified model structures. The
question is therefore not how to entirely eliminate errors arising from the
imperfect estimation of the parameters but rather how to minimize these errors.
Yet, due to the novelty of the search theoretical approach presented here, no
special error-minimization techniques are available, and developing such techniques
is beyond the scope of this work. The section deals therefore mainly with the mere
ability to determine, at least roughly, the values of the required parameters.
There are six parameters in the relative real estate search model that are required
for the computation of marketability and liquidity risk measures. These are:
relative offer volatility (), frequency of offer arrivals (), market trend (),
market trend volatility (), relative rental revenues (), and discounting rate ().
Furthermore, as soon as the purchase case is considered, values of the respective
parameters from the buyer's point of view are required. In the following, the
possibilities of obtaining each of these parameters are discussed. Since the most
severe problems are encountered with respect to the volatility of offers and the
offer arrival frequency, separate subsections are devoted to these parameters. The
remaining ones are far less problematic and are addressed in the last subsection.
5.1.1. Volatility of Offers

The nature of the parameter has already been discussed in section 2.4 in Chapter
2. In general, it should correspond with the dispersion of valuations of the asset
in question among potential buyers. Assuming that bids are placed in a random order
makes the selling process similar to drawing randomly from the distribution of
valuations. Hence, instead of determining the volatility of offers, it would be
sufficient to determine the standard deviation of the values assigned to the
property by potential buyers.
5.1 Determination of Model Parameters

309

Yet, obtaining such information may still be highly problematic. In fact, there is
only little literature on the distribution of valuations for real estate.458 If the
number of market participants is small, it is theoretically possible to estimate
the valuation of the property by every single potential buyer. This may be the
case, e.g., for specialized industrial properties, which only few investors can be
interested in. In such cases, market participants may know each other well enough
to be able to assess the value of the property for each of the parties on the basis
of their individual situations, their corporate structures, or strategic
orientations. On the other hand, however, it is questionable, whether it is at all
worthwhile to apply search theory with such a limited number of bidders. In
particular, the real estate search model from Chapter 2 is not suitable in such
cases as it does not limit the maximal possible number of offers. A modification of
the model allowing for a bounded search horizon (see section 2.3.3.1) would be
necessary; this, however, would lead to the non-existence of a single reservation
price and would significantly complicate the computation of statistical parameters
for liquidation receipts. A more common situation, in which the application of the
real estate search model is more suitable, is the sale (or purchase) of investments
traded in markets with large groups of participants. Popular types of real estate,
like residential or office properties, as well as many other illiquid assets (e.g.,
popular collectibles) belong to this category. In this case, the population from
which the offers are "drown" is too large to review all its members and can be
analyzed only by sampling. One way to estimate the distribution of buyers'
valuations is by questioning. A traditional survey is, however, not likely to
provide satisfactory results in this case; one can hardly expect potentially
interested investors to reveal truthfully their estimations of the property's
value. A possibly more accurate estimation of offer dispersion can be achieved on
the basis of professional opinions. Experienced market players, like big real
estate agents, are likely to be able to provide fairly precise statements on the
distribution of valuations for certain types of properties in certain locations.
This approach would be probably preferable for large real estate companies whose
employees have expert knowledge about the markets on which they are active.
However, expert opinions are far more difficult to obtain by new or less
experienced investors. They can also be biased due to specific
458

See Merlo/Ortalo-Magn (2004) or Leung et al. (2006) for studies addressing the
dispersion of real estate prices and valuations.
310

Chapter 5: Liquidity of German Condominium Markets

fields of competence of the individuals or institutions who issue them. Thus,


estimation based on objective empirical data might be preferable in some cases. The
most straightforward way is to fall back on prices realized for comparable
properties. Yet, the question arises in this case, to what extent realized prices
reflect buyers' valuations and their readiness to pay. According to the economic
logic, a transaction can be closed only when the buyer's valuation is not lower
than the seller's valuation; the transaction price lies between these two values
and depends on the bargaining powers of the parties. In effect, the distribution of
prices should tend to lie further to the right than the sellers' valuations and
further to the left than the buyers' valuations.459 Thus, the estimation of the
dispersions of valuations based on transaction prices may be biased. The extent of
the bias depends mainly on the distance between the sellers' and the buyers' side
of the market (market breadth). However, one could intuitively expect that the bias
should not be large under normal market conditions and that in would increase in
times of temporary market inequilibriums. Another issue that arises when the
dispersion of valuations is estimated on the basis of transaction prices is the
comparability of the latter. Theoretically, all prices should refer to properties
identical with the analyzed one. However, heterogeneity is one of the main
characteristics of real estate, and it is also distinct with respect to other
privately traded assets. Full identity of properties is therefore practically
impossible alone because of the uniqueness of the locations no two properties can
exist in one and the same place. Thus, when considering a specific property, only
transaction prices achieved for similar objects can be regarded. Identifying a
sufficient number of such comparable properties is not difficult when large amounts
of data are available. However, this is possible with respect to only very few real
estate markets in which transactions occur frequently and their outcomes are
publicly known. Most property markets suffer from very low trading frequencies and
poor data availability. In effect, the number of data points may be too small to
allow a meaningful estimation of the valuation diversity when only comparable
properties are selected from among the available ones. A possible way to cope with
this problem is the application of hedonic techniques analogues to those used in
the construction of real estate indices.460 By regressing the features of
heterogeneous properties on the transaction prices achieved for them, not only the
average contributions of these features to the total value but also their standard
459 460

See also the discussion in section 2.4 and Figure 2-6. See FN 267.
5.1 Determination of Model Parameters

311

deviations can be computed. The variability of prices for a hypothetical property


with predefined characteristics can be estimated on the basis of these deviations.
This approach allows the utilization of information contained in the prices of
objects not directly comparable with the analyzed one, which would be discarded
otherwise. The final possibility to estimate the volatility of offers is to build
on the observed volatility of real estate appraisals or the appraisal errors. This
approach is founded on the assumption that the majority of buyers and sellers
acting in real estate markets judge the fair values of properties on the basis of
opinions issued by appointed appraisers. In this sense, the distribution of
valuations can be viewed as derivative to the distributions of appraisals obtained
by market participants. It follows that the divergence of appraisals should be
related to the divergence of sale or purchase offers received during the marketing
process. This approach may, however, contain a substantial bias. Firstly, in many
cases the valuation of a property depends on the possibilities of using it by the
concrete individual or institution or on its "fit" in her existing portfolio. In
contrast, appraisers are concerned about the average value achievable on the
market. Secondly, many of the real estate transactions, especially the transactions
for residential properties, are made (at least partially) on the basis of
individual tastes, which are also not covered by appraisals. Hence, this approach
can be useful only in real estate markets dominated by professional investors; in
other markets it may lead to an underestimation of the true offer volatility.461
5.1.2. Offer Arrival Frequency

The determination of the offer arrival frequency () is insofar different from the
determination of the dispersion of offers as it cannot be easily derived from a
characteristic of buyers' (or sellers') population such as the distribution of
valuations. The decision to bid on a property is a function of investor's current
situation as well as the effect of more or less random incidents (e.g., finding a
sale advertisement). In effect, the probability of placing an offer can be hardly
analyzed on the individual level, and the population of potential buyers needs to
be considered as a whole. Furthermore, there is little sense in assessing the offer
arrival frequency in markets with only few players. In such markets, like the
already mentioned special industrial property market, offers
461

Empirical results on the divergence of appraisals or the appraisal errors (i.e.,


the deviations of appraisals from the subsequent transaction prices) lead to very
different results ranging from 2% to 20%. See, e.g., Kain/Quigley (1972), Diaz
(1997), or Graff/Young (1999).
312

Chapter 5: Liquidity of German Condominium Markets

would most probably be placed all at the same time meaning that the search does not
have a sequential character. Hence, the application of the real estate search model
is pointless unless it is redefined in terms of a fixed sample search strategy (see
section 2.2.2). This step would, however, lead to significant complications
regarding the computation of liquidation receipts and other relevant variables. For
this reason, the field of model application is limited to markets with large
(practically infinite) numbers of participants. The most straightforward approach
to the estimation of the offer arrival frequency is the analysis of this variable
in past transactions on similar properties. Given a sufficient number of sales with
full histories of bids that have been placed during the marketing periods, the
average number of bids per unit of time or the average time between bids can be
used as a proxy for the required model parameter. Of course, the quality of such a
proxy depends on the comparability of properties and on the time period in which
the sales were observed. The latter point requires particular caution; not only
sales in the far past but also sales that occurred during, before or after
important market events may not reflect the typical offer arrival frequency for the
analyzed property. If these problems are given adequate attention, estimation on
the basis of transaction histories should provide best results. However, the
availability of such data may prove highly problematic. One would expect large
players, like real estate companies, funds, or big brokerage houses, to have
sufficient own transaction histories at their disposal to be able to use them for
that purpose. In order to further improve the estimation of , a hedonic approach
could be used - the number of offers per period could be regressed on the
characteristics of properties in the databank. This way, all available information
could be utilized without the necessity to discard noncomparable properties.
However, transaction histories are usually proprietary, so that smaller players
with less experience and no sufficiently large databanks on real estate
transactions may have significant difficulties in accessing them. Only a very rough
assessment of the offer arrival frequency on the basis of public information is
possible in this case. There seems to be no straightforward solution to this
problem; merely a number of rough hints for the approximate value of can be given.
The simplest approach is to assess the relations between the respective parameters
for different markets on the basis of trading intensities on these markets. It
seems plausible that one property type that is
5.1 Determination of Model Parameters

313

traded twice as frequently as some other property type should also have
approximately twice the number of offers per period. However, one should be aware
that such a statement can be burdened with very high inaccuracy. On the one hand,
the relation does not need to be linear a complex analysis would be necessary to
state its functional form. On the other hand, there are also a number of other
factors affecting , like the marketing channels of the seller. Nevertheless, with
no better alternative, this is probably the only approach allowing any approximate
determination of the offer arrival frequency when lacking more precise transaction
data. 5.1.3. Other Parameters

The remaining model parameters are easier to estimate than the offer volatility or
the arrival frequency. In particular, they can be estimated on the basis of
publicly available data such as real estate indices. The main ones, such as the
U.S. American NCREIF index or the European indexes provided by the Investment
Property Databank (IPD), are subdivided into types of real estate as well as into
appreciation and rental components. This allows an almost direct determination of
both the expected price change (market trend, ) and the volatility of price changes
(volatility of the trend, ) as well as the relative rental revenues () for the
required property type. A drawback of this approach is the relatively gross
delimitation of real estate markets; indices usually differentiate only between the
main property types (e.g., residential, office, retail, industrial) and between
very broad geographic regions (e.g., countries in Europe or states in the USA).
More accurate results can be possibly achieved by using regional indexes published
for more narrowly defined markets; yet, it is also possible that these are based on
smaller data sets, what would negatively affect their accuracy. The final
parameter, the discounting rate , is by its nature subjective and needs to be
determined for each investor individually. When specifying its value, one needs to
bear in mind that it depends on the character of the liquidation. In particular,
one needs to differentiate between a planned and a forced liquidation, as discussed
on several occasions in earlier chapters.462 In former case, an illiquid investment
(property) is held until the end of its holding period; in the latter case, the
liquidation is forced prematurely due to an unexpected liquidity event. The
discount rate should be regularly higher in the second case.
462

See especially sections 1.4.2.2 and 4.4.2.


314

Chapter 5: Liquidity of German Condominium Markets

To sum up, the determination of model parameters can cause serious practical
problems, especially with respect to offer volatility and arrival frequency. These
problems are especially severe for investors with poor access to detailed market
information. In contrast, large market participants, who have been active on the
analyzed market for a long time and have detailed histories of numerous
transactions at their disposal, should have no problems with the practical
application of the search model. It follows that the techniques of measuring and
managing liquidity of real estate investments proposed in this book are most
suitable for large institutional investors, like large real estate companies, real
estate funds, or agents. Smaller market participants and investors who act on real
estate markets only infrequently can be expected to have more difficulties
achieving satisfactory results. But also in their case, an imperfect method of
coping with illiquidity is still better than no method at all.

5.2.

Condominium Liquidity Analysis

In this section, German residential condominium markets have been chosen to


demonstrate the application of search theoretical methods in practice. Basing on
this example, two central questions are addressed: Do different measurement
approaches lead to the same or at least similar classification of real estate
submarkets with respect to their liquidity? And does the inclusion of a liquidity
criterion result in a different optimal portfolio than the one that would be
selected without liquidity considerations? A positive answer to these questions
would mean that special attention needs to be given to the choice of the
appropriate method when the real estate search model is to be applied for dealing
with liquidity. In contrast, negative answers would indicate (but not prove) higher
independence of the result from the chosen method of analysis. In view of different
structures of the approaches presented in earlier chapter as well as different
notions of liquidity underlying them the first possibility seems more probable.
This expectation is also confirmed by the empirical analysis in this section. In
the first subsection data material is presented. It consists mainly of information
available publicly, though not free of charge. The second subsection deals with
liquidity measurement. Selected methods based on the real estate search model and
discussed extensively in Chapter 3 are applied to German condominium markets.
Finally, portfolio optimization is conducted. The traditional mean-variance
approach is extended to include the possibility of a strategic liquidation.
5.2 Condominium Liquidity Analysis 5.2.1. Data Material

315

The empirical study is based on data referring to condominium markets in five large
German urban areas: Cologne, Duisburg, Frankfurt, Hanover, and Stuttgart. It comes
from two sources. One of them encompasses average residential condominium
transaction prices assessed by brokers who are members of Immobilien Verband
Deutschland (IVD) or Ring Deutscher Makler (RDM, before 2005).463 The other source
consists of transaction prices for condominiums provided by German Appraisers'
Committees Gutachterausschsse fr Grundstckswerte (GAA) official bodies
collecting, processing, and providing to the public information on local real
estate markets.

5.2.1.1. RDM/IVD Data


IVD and previously RDM is (and was) the biggest German association of real estate
brokers with over 6000 members.464 Since 1971 it publishes a review of real estate
prices (Immobilienpreisspiegel), which contains information on average rents and
sale prices for residential and commercial properties in over 250 selected cities.
The data is provided by member brokers as their assessments of average rents and
price levels made on the basis of transactions by their clients.465 Since the study
in this Chapter refers only to residential real estate, only this type of IVD/RDM
data is used. All figures refer to a (hypothetical) standard condominium with 3
rooms and about 70 m space. From about 350 towns included in the reports only
Cologne, Duisburg, Frankfurt, Hanover, and Stuttgart have been selected. These are
all large urban areas with populations exceeding 500,000, lying in different
geographical regions of Germany, and having different economic backgrounds. For
this reason, they can be regarded as separate markets. Furthermore, IVD/RDM
differentiates rents and prices according to the quality of condominiums
distinguishing good, medium, and poor quality. These categories include both a
location component and a facility component; they can be used to delimit further
submarkets. However, only the good and the medium category are considered in the
following study; the poor quality category is ignored due to insufficient data. In
effect, ten condominium markets are
463 464 465

IVD has emerged in 2005 as a merger of RDM with Verband Deutscher Makler (VDM). See
http://www.ivd.de for further information. See comments to the IVD/RDM Preisspiegel
(1972-2006).
316

Chapter 5: Liquidity of German Condominium Markets

defined referring to two quality categories in each of the five cities. For
simplicity, the categories are denoted as G and M for good and medium quality,
respectively. The differentiation between age classes, which is also provided by
IVD/RDM, is disregarded here only condominiums constructed after 1949 but prior
to 2006 (no new buildings) are considered. Rents and prices for the ten submarkets
are available annually for the time period 1972-2006.

5.2.1.2. GAA Data


"Gutachterausschsse fr Grundstckswerte" are appraisers' committees founded on
the basis of the German Construction Code (Baugesetzbuch, BauGB) and committed to
ensuring transparency of real estate markets.466 Official regulations require that
every real estate transaction is reported by the notary to the regional GAA. The
report includes the price, the location, as well as the main characteristics of the
property. On the basis of this information, GAAs fulfill their statutory
obligations including especially the provision of summary information on land
prices and other data necessary for the appraisal of properties in the region.
Certain types of data are usually provided free of charge, while others, especially
prices for comparable properties, are provided against a fee. The fact that GAAs
collect all information about real estate transactions in their range of authority
makes them the potentially most powerful source of information in the branch with
probably no similar counterparty worldwide. The use of the vast databanks for
commercial or scientific purposes is, however, limited for two reasons. Firstly,
the data is scattered theoretically, a separate GAA should exist in each of over
14,000 German towns and communities (Gemeinde). Not only there is no unified
central databank system, but also the form of records differs from one GAA to
another. Secondly, inquiries about transaction prices are usually charged on "per
price" basis. Obtaining hundreds or thousands of prices, which would be necessary
for a statistically significant parameter estimation of any model, even if it was
granted by the GAA, would result in an enormous cost that would be probably only
seldom justified. Hence, these enormous amounts of data are still, to a great
extent, unavailable for market research. However, thanks to the kind assistance of
the GAA Cologne, GAA Duisburg, GAA Frankfurt, GAA Hanover, and GAA Stuttgart
summary statistics or lists of
466

See BauGB 192 ff.


5.2 Condominium Liquidity Analysis

317

transaction prices for condominiums in these cities have been made available for
this study.467 This unique set of data can be used for the estimation of search
model parameters, in particular, for the estimation of the divergence of valuations
among market participants. The data for Cologne encompasses summary statistics of
condominium prices for the time period 1996-2006. Separate reports are available
for each city district including the number of evaluated transactions, average
prices, and standard deviations of prices. Estimation of the location quality was
possible on the basis of general opinions about the qualities of the districts. The
data for Duisburg consists of a selection of nearly 3300 condominium transactions
between 1996 and 2006. Apart from transaction prices, construction years, location
qualities, and condominium sizes are reported in each case. The data for Frankfurt
encompasses the number of transactions in each year between 1996 and 2005 as well
as annual means and standard deviations of transaction prices in years 2004 and
2005. The statistics are reported separately for poor, middle, and good location
quality and refer to condominiums in building constructed between 1949 and 2005.
The Hanover data is comprised of a selection of nearly 3000 transaction prices in
the time period 1997-2006 together with the associated information on the
construction year (being after 1949), condominium size, average land price in the
respective location, and the quality of facilities (being poor, middle, or good).
Finally, the Stuttgart data includes a list of nearly 14,000 transactions for
condominiums constructed between 1949 and 2005 and sold in the time period 1995-
2005. Apart from transaction prices the data includes assessments of the flats'
locations and facilities' quality, as well as sizes; the quality information is
reported in form of points that sum up a number of various features. In order to
ensure the compatibility of GAA data with IVD/RDM data, two submarkets have been
defined for each of the five urban areas: a submarket for medium quality
condominiums and a submarket for good quality condominiums. The classification was
made on the basis of all available quality information. For Cologne, Duisburg, and
Frankfurt, it was limited to the location quality only; for the Hanover and
Stuttgart also the quality of facilities has been included.468 Furthermore, for the
computation of the
467

468

The author would like to express his gratitude to the GAA Frankfurt, GAA Hanover,
and GAA Stuttgart for providing data for this study free of charge. In Hanover,
location quality has been qualified on the basis of land prices associated with the
locations of properties the upper 1/3 quantile has been qualified as good, the
middle 1/3 quantile as
318

Chapter 5: Liquidity of German Condominium Markets

offer volatility in Duisburg, Hanover, and Stuttgart, the data was filtered to
include only condominiums with sizes between 50 and 90 m, which is approximately
-/+ 30% of the standard size of 70 m to which the IDV/RDM data refers. In
consequence, the amount of data for these cities was reduced to ca. 2300, 1900, and
4300 records, respectively. Due to the lack of sufficient information, no such
adjustment could be made for Cologne and Frankfurt. In addition to the information
on condominium transactions, broadly defined turnover data for local condominium
markets in 2005 or 2006 (depending on the availability) was used.469 It originated
from the publicly available property market reports published by the GAAs in the
analyzed cities.470 On this basis and on the basis of the information about the
populations of the cities in 2005/2006, the average number of transactions per
inhabitant was calculated. The values for different quality categories were
determined according to the proportions in which different qualities were present
in the samples of the transaction data received from the GAAs. Estimated numbers of
sales of different condominium types per inhabitant were applied to estimate offer
arrival frequencies. It is apparent from the above description of the data that no
perfect comparability of information on condominium markets in the five analyzed
cities can be ensured. In the first place, the delimitation of the sub-markets was
arbitrary and partially conducted on the basis of different quality criteria, i.e.,
a "good condominium" in Frankfurt is most likely not the same as a "good
condominium" in Stuttgart. Secondly, the sample sizes differ strongly; while only 2
years are included in Frankfurt, 11 years are considered in Stuttgart. Finally, the
types of condominiums included in the samples are slightly different; e.g., the
adjustment for the condominium size could be made for Duisburg, Hamiddle, and the
lower 1/3 quantile as poor. The combination of location quality and facilities'
quality to obtain the overall condominium quality followed the following scheme:
good + good = good, good + middle = middle, good + poor = middle, middle + middle =
middle, middle + poor = poor, poor + poor = poor. For Stuttgart, quality
information was available in "quality points"; the overall condominium quality was
computed as the average of the location quality and the facilities' quality and
translated into good, middle, and poor according to the upper, middle, and lower
1/3 quantile of the resulting average points. Although the detailed transaction
data provided by the GAAs also included numbers of transactions, the figures
referred apparently to sample sizes rather than to total turnovers. In order to
ensure comparability of the data, it was necessary to fall back on more general
figures published in the GAAs' annual property market reports. See: GAA Cologne
(2006), GAA Duisburg (2006), GAA Hanover (2006), GAA Frankfurt (2006), and GAA
Stuttgart (2006).

469

470
5.2 Condominium Liquidity Analysis

319

nover, and Stuttgart, but it was not possible for Cologne and Frankfurt. In effect,
one has to bear in mind that the criteria according to which markets are delimited
in this study are not fully consistent. Such problems are, however, typical to real
estate markets and are encountered both by researchers and practitioners alike.
Property markets, and especially residential property markets, are local by their
nature and the criteria of their classification are always defined with respect to
the local conditions or customs. Therefore, the data is used "as it is" without an
attempt to unify it. Slightly more disturbing is the lack of full consistency
between GAA and RDM/IVD data. In particular, the former source includes real
transactions on real properties while the latter one refers to an abstractly
defined standard condominium. Unfortunately, this problem can be hardly coped with
without significant reductions of sample sizes (especially the lengths of returns
time series), so that the resulting biases have to be accepted. However, since both
sources of data refer in the core to the same condominium markets, the biases
should not be higher than in typical studies of real estate investments.

5.2.1.3. Determination of Model Parameters


The data presented in the former subsection was used to determine the parameters of
the real estate search model and the portfolio selection model for the ten property
submarkets delimited on the basis of location and quality criteria. On the one
hand, RMD/IVG data was applied to determine return statistics (expected returns and
return volatilities) as well as long term price trends (), uncertainty about the
trends (A), and relative rental revenues (). On the other hand, GAA data was used
to estimate offers volatilities () and offer arrival frequencies (). Returns have
been defined as total returns encompassing the rental and the appreciation
component. The following return formula was used:471

471

The application of discrete rather than continuous (logarithmic) returns, which are
otherwise more common in finance, is dictated by the methods applied in the
analysis of a planned strategic liquidation in section 5.2.3.1. A correction for
search effects would be impossible with log-returns.
320
R= Pt - Pt -1 + 12 H t Pt -1

Chapter 5: Liquidity of German Condominium Markets (5.1)

with: Pt Ht

- price in the year t - monthly rent in the year t

On the basis of total returns, expected values, standard deviations, and


correlations were calculated; they are necessary for the application of the
standard portfolio selection model. The results are summarized in Table 5-1.
Table 5-1: Return statistics for selected German condominium markets Frankfurt M
Duisburg M Frankfurt G Duisburg G Hanover M Stuttgart M 8.27 21.05 0.21 0.36 0.33
0.45 0.09 0.67 -0.07 0.28 0.75 1.00 Cologne M Hanover G Stuttgart G 6.69 13.02 0.29
0.38 0.49 0.62 0.26 0.74 0.05 0.41 1.00 Cologne G 7.25 17.17 Parameter E(R) [in %]
S(R) [in %]

7.78 15.94

6.08 9.76

6.31 11.64

7.66 17.30

7.42 9.60

6.62 17.41

7.10 11.11

Correlations Cologne G Cologne M Duisburg G Duisburg M Frankfurt G Frankfurt M


Hanover G Hanover M Stuttgart G Stuttgart M 1.00 0.62 1.00 0.42 0.30 1.00 0.51 0.28
0.60 1.00 0.35 0.17 0.13 0.24 1.00 0.46 0.59 0.34 0.44 0.20 1.00 0.34 0.14 0.34
0.12 0.76 -0.03 1.00 0.10 0.27 0.08 0.11 0.10 0.46 0.08 1.00

The time series of average condominium prices per square meter were also used to
determine the expected trends of liquidation prices () and the trend uncertainty
parameters (A) required in the search model. In each case, the former parameter was
calculated as the average continuous appreciation return ln(Pt)-ln(Pt-1), and the
latter was defined as the standard deviation of the appreciation returns.
Furthermore, relative rents were estimated as average ratios of rental revenues to
condominium prices (12H/Pt-1).
5.2 Condominium Liquidity Analysis

321

The remaining search model parameters were estimated on the basis of GAA data. The
volatility of offers was approximated by the average annual dispersion of
transaction prices. In the first step, standard deviations of transactions in each
sub-market were calculated for each available year; they were averaged in the
second step yielding an estimation of . Estimation of offer arrival frequencies
proved to be most difficult. Since neither average times between offers, nor
average numbers of offers during a liquidation process were available for the
analyzed markets, the choice of this variable's values had to be arbitrary. One
offer per day, or 365 per year, was assumed as the starting point.472 This value
was associated with the condominium sub-market exhibiting the highest activity,
which was the Hanover M (medium quality) market. For other markets, the arrival
frequency was assumed to be proportional to the market activity measured as the
approximate annual number of transactions per inhabitant. The result is, of course,
only a very rough estimation, highly dependent on the accuracy of the initial
"guess" and the grade of linearity in the relationship between and the number of
transactions per capita. Such a rough approximation is sufficient for the exemplary
computations intended in this Chapter; for serious practical applications, however,
a more precise method would be necessary. As discussed in section 5.1.2, it should
be preferably based on long term experiences of professional investors. Discounting
factors () were set arbitrarily at the level of 5% for the planned liquidation and
25% or 50% for the forced (unplanned) liquidation. Table 5-2 summarizes the
estimations of the main search parameters for the analyzed condominium sub-markets.

472

The base arrival frequency of one offer per day is roughly based on the experiences
of several interviewed real estate brokers in large German cities and refers to
good quality condominiums in preferred locations.
322

Chapter 5: Liquidity of German Condominium Markets

Table 5-2: Parameters of the search model for selected German condominium markets
Frankfurt M Duisburg M Frankfurt G Duisburg G Hanover M Stuttgart M 1.9% 19.5% 4.4%
19.6% 296.44 Cologne M Hanover G Stuttgart G 1.7% 12.5% 4.2% 18.3% 148.87 Cologne G
1.6% 17.6% 4.2% 32.7% 121.67 Parameter A

1.9% 16.0% 4.7% 26.1% 244.33

1.2% 9.6% 4.4% 23.4% 19.31

0.8% 10.6% 4.9% 32.4% 99.11

2.2% 14.8% 4.3% 31.1% 24.07

2.4% 8.8% 4.6% 36.5% 197.82

0.2% 16.0% 5.1% 22.6% 92.87

0.9% 10.0% 5.7% 24.7% 365.00

As already mentioned, the precision of estimations could be improved if more


precise data was available. The main problem is the imprecise estimation of the
offer arrival frequencies. Since the following study is conducted mainly for the
purpose of demonstrating the developed methods rather than for analyzing concrete
markets, these issues are not of crucial importance here. However, in a serious
practical application, a more thorough analysis would be necessary at this point.
Only then the result could be expected to provide good rationale for investment
decisions. Due to the novelty of the approach, no specialized software was
available for the search theoretical analysis. Therefore, Microsoft Excel was used
in most cases. Routines for the necessary calculations, in particular algorithms
for calculating expected values, variances (standard deviations), and covariances
(correlations) of net sale receipts, were programmed in Visual Basic for
Applications (VBA) attached to the Excel package. Wherever numerical estimation or
optimization was necessary, the included Solver routine was used. This was
necessary, in particular, for the determination of optimal reservation prices and
for portfolio optimization in the last section. Thus, the precision of the results
depends on the effectiveness of the Solver. In this context, it must be noted that
this software conducts only local optimization, which is highly dependent on the
starting variable values. Unfortunately, it was not possible to verify whether all
solutions were also global optima, so it is theoretically possible that a
recalculation with different initial values could lead to different results. The
general conclusions from the analysis should, however, not be affected by these
minor inaccuracies.
5.2 Condominium Liquidity Analysis 5.2.2. Liquidity Measurement

323

The following section deals with the measurement of liquidity for the residential
condominium markets delimited and described earlier. Although it is highly
interesting whether and to what extent these markets differ in this respect, the
main purpose of the section lies in the comparative analysis of different
measurement approaches developed and presented in earlier chapters. In total, eight
different measures are tested, representative for each of the groups discussed in
Chapter 3. Their comparison is based, on the one hand, on the implications
regarding the nature of trading in respective markets and, on the other hand, on
the relative classification of the markets with respect to their liquidity.

5.2.2.1. Market Depth


Probably the most popular measure of market depth and simultaneously the simplest
indicator of market liquidity is the average trading volume observed within a
certain time window. However, as already discussed in section 3.1.2.3, trading
volume or turnover may yield misleading results when applied to real estate
markets. Large transaction sizes, which are the effect of poor divisibility of
properties, may lead to immense trading volumes caused by only few trades. In fact,
however, there may be only few players active on such markets making them very
shallow and their liquidity comparably poor. This effect may also occur in
residential property markets, although it is probably less severe there than in the
case of more specialized properties like industrial real estate. Thus, it seems
that the number of transactions is a much better liquidity indicator in this case.
More frequent transacting implies a larger number of interested buyers and sellers
and seems to be more suitable to estimate the chances of a successful liquidation.
Yet, it must be noted that the numbers of transactions in different real estate
markets are only comparable if the considered markets are of similar sizes. If it
was not the case, the figure would misleadingly tend to indicate higher liquidity
of more broadly delimited markets e.g., there are obviously more condominium
transactions in London than in Frankfurt, but it does not necessarily mean that the
London condominium market is more liquid. Hence, it is the transaction intensity
rather than the absolute number of transactions that is relevant for liquidity. It
can be defined as the ratio of the realized property transactions in a certain
market to the total number of buyers and
324

Chapter 5: Liquidity of German Condominium Markets

sellers willing to transact. Unfortunately, the number of properties available for


trading during the considered time interval is not directly observable in most
cases. The second best solution would be the utilization of the total value or the
total number of properties of a certain type in the considered geographical
submarket, but even this kind of data is rather difficult to obtain and possibly
instable over time. The third possibility, which is conceivable for residential
real estate, is to fall back on the population of the considered region. A close
relation between the population and the local demand for living space seems
plausible. Thus, the number of transactions per inhabitant can be considered as a
proxy of the transaction intensity. One should note, however, that biases may
result from differences in the local social structures. With the same total
population, the demand for high quality condominiums, and consequently their
liquidity, can be expected to be higher in wealthier regions. However, this effect
should be of only marginal importance for the cities analyzed in this Chapter.
Since they are all large urban areas in western Germany, the social structures
should not differ significantly. Hence, estimated numbers of transactions per
inhabitant are used as the first liquidity indicator. They are summarized in Table
5-3.
Table 5-3: Estimated number of transactions per inhabitant in selected German
condominium markets Frankfurt M Duisburg M Frankfurt G Duisburg G Hanover M
Stuttgart M 563 Cologne M Hanover G Stuttgart G 283 Cologne G Number of
transactions 231

464

37

188

46

376

176

693

Most striking in the above results are high differences between the transaction
intensities in the analyzed markets. In particular, it is possible to classify the
cities in two separate groups with distinctly different levels of transactions per
inhabitant: the first one includes Duisburg and Frankfurt and the second one
includes Cologne, Hanover, and Stuttgart. This may be the effect of the differences
in the social and/or economics structures, but it may also be due to the specific
delimitation of the sub-markets.

5.2.2.2. Market Breadth


The Implicit Spread and the Quick Sale Discount, both based on the real estate
search model, have been proposed as measures of breadth for real estate markets in
sections
5.2 Condominium Liquidity Analysis

325

3.1.2.1 and 3.1.2.2, respectively. The first measure is computed as the difference
between the maximum selling price and the minimum purchasing price valid for a
hypothetical risk-neutral dealer. The purchase price offered by such a dealer (bid)
would not be higher than the minimum expected expenditure achievable under the
optimal search strategy; analogically, the sale price (ask) would not be higher
than the maximum expected liquidation value. This logic implies that the
hypothetical dealer is not under time pressure when purchasing or liquidating
according to the optimal strategy. Hence, also his opportunity cost should not be
high, and the discounting rate at a lowrisk investment level seems appropriate; the
rate of 5% has been chosen for this purpose. While the Implicit Spread takes both
sides of the market into account, the Quick Sale Discount refers to the sellers'
side only. It attempts to answer the question: how much of the asset's value the
investor is expected to lose by selling quicker than optimal? A "quick sale" is
defined in terms of the search model as a sale accomplished at an infinite negative
reservation price, or in other words, a sale to the fist interested buyer
encountered in the liquidation process. The so defined discount is highly sensitive
to the situation of the investor, in particular, to the pressure under which she is
selling. Allowing for alternative scenarios, three different (annual) discounting
rates are applied: 5% for a fully flexible investor with no pressing need to sell,
25% for an investor under moderate pressure, and 50% for an investor who is likely
to face severe consequences if the asset is not sold promptly. The computations of
the measures are conducted according to the formulas (3.10) and (3.12),
respectively. The results, including reservations prices for the sale and for the
purchase case, are summarized in Table 5-4.
326

Chapter 5: Liquidity of German Condominium Markets

Table 5-4: Market breadth measures for selected German condominium markets
Frankfurt M Duisburg M Frankfurt G Duisburg G Hanover M Stuttgart M 1.22 39.4 30.2
27.4 1.65 0.43 Cologne M Hanover G Stuttgart G 1.06 35.7 26.3 23.2 1.55 0.50
Cologne G Implicit Spread QSD ( = 5%) in % QSD ( = 25%) in % QSD ( = 50%) in % *:
Sale *: Purchase 1.83 48.4 39.5 36.0 1.94 0.11

1.59 45.7 36.5 33.5 1.84 0.25

1.05 35.4 22.5 17.8 1.55 0.50

1.74 47.0 38.4 34.8 1.89 0.15

1.52 45.4 30.6 25.6 1.83 0.31

2.23 54.3 44.5 41.3 2.19 -0.04

1.19 37.6 29.1 25.7 1.60 0.41

1.51 44.1 36.3 33.6 1.79 0.28

The immense dimensions of the spread are striking at first sight they lie between
one and two times the average valuation of the condominium. This is obviously the
result of very high sale reservation prices and very low purchase reservation
prices that allow the hypothetical dealer achieving respectively high expected
liquidation receipts and low expected purchase expenses. In the extreme case of the
medium quality condominiums in Frankfurt, it is optimal for the dealer to buy at a
negative price and to sell at over the double of the average valuation. This result
is caused, on the one hand, by the high dispersion of valuations (historical
transaction prices) and, on the other hand, by the low time preference (discount
rate = 5%). In effect, the reduction of the liquidation value incurred when
postponing the sale is practically compensated by the rental revenues earned in
this time. Hence, as long as the dealer is risk neutral and concerned only about
expected values, he would act rationally by waiting patiently for an extremely good
offer rather than selling or buying at an average price. He would have no incentive
to quote narrower spreads than those presented in Table 5-4. This result may seem
absurd at first sight, especially when compared with the dimensions of spreads in
financial markets. Nevertheless, even if lacking realistic interpretations, these
figures give a good impression of how illiquid direct real estate investments in
fact are. Furthermore, it becomes increasingly clear that liquidity risk cannot be
ignored even by a very large investor (dealer), so that using only the Implied
Spread, in which risk neutrality is assumed, leads to a biased picture of the true
liquidity of real estate investments.
5.2 Condominium Liquidity Analysis

327

The results for the Quick Sale Discount confirm the conclusions from the analysis
of the Implied Spread. At the discount rate of 5%, quick selling leads to losses of
up to 50% compared with the value that could be realized with the strategy
maximizing the expected net receipts. The discount decreases, however, when a
higher pressure to sell is assumed. This is understandable higher opportunity
costs faced by the investor in such cases decrease the value of search, so that a
quick liquidation is comparably cheaper. Yet, even with the discounting rate as
high as 50%, the discounts are still very high reaching up to 40%. This means that
even if waiting leads to a rapid loss of value, as it could be expected, e.g., in
an insolvency case, it is still suboptimal to sell without a thorough search for a
buyer. However, also this measure does not take liquidity risk into account. The
"optimal sale strategy" is here the one that maximizes the expected net receipts;
yet, it is possible that the "quick sale" and the "optimal sale" involve utterly
different levels of uncertainty.

5.2.2.3. Time on Market


Representative for the group of time- and probability-based measures, the expected
duration of the liquidation process is used. It corresponds with the Time-on-
theMarket; however, while ToM is usually estimated empirically, the measure used in
this section is implicit and computed on the basis of the search model. It is
defined as the reciprocal of the probability of receiving an acceptable offer
(i.e., one that exceeds the reservation price) times the expected time between
offers, which equals the reciprocal of the offer arrival frequency (see formula
3.17). The main problem with the computation of ToM is the choice of the adequate
reservation price. According to the proposition of Lippman/McCall (1986), the price
leading to the maximum expected net receipts should be used. However,
considerations regarding liquidity risk have shown that also other reservation
prices may be rational, like e.g., the one leading to the minimum liquidity risk or
the one for which a subjectively optimal combination of expected receipts and risk
is achieved. To avoid these problems, two versions of the measure were computed:
the reservation price maximizing the expected net receipts was used in ToMmax, and
the reservation price minimiz-
328

Chapter 5: Liquidity of German Condominium Markets

ing the receipts volatility was used in ToMmin. The results are summarized in Table
55.473
Table 5-5: Expected ToM of condominiums in selected German condominium markets
(days) Frankfurt M Duisburg M Frankfurt G Duisburg G Hanover M Stuttgart M 2697 25
88 22 44 16 Cologne M Hanover G Stuttgart G 2016 40 93 31 48 20 Cologne G ToMmax
( = 5%) ToMmin ( = 5%) ToMmax ( = 25%) ToMmin ( = 25%) ToMmax ( = 50%) ToMmin ( =
50%) 1454 43 129 38 68 28

2372 35 105 30 54 21

1978 100 161 74 90 51

1204 67 132 49 71 32

4063 78 182 70 100 52

3327 68 130 45 67 28

1008 42 110 36 59 26

1439 45 95 31 49 19

In the above results, the large discrepancies between the expected ToMs computed at
minimum and maximum reservation prices are particularly surprising. According to
them, an investor acting without time pressure (under 5% discount rate) and
following the strategy that maximizes expected net sale receipts should expect to
be searching for a buyer for several years - the extreme value is reached for
medium quality condominiums in Frankfurt with over 10 years expected search
duration. On the other hand, following the risk minimizing strategy leads to
expected durations of the liquidation process of only few months. Both ToMmax and
ToMmin decrease rapidly when opportunity costs increase. In most cases they are
below three months and one month, respectively, when a discount rate of 50% is
assumed. Even under such extreme time pressure, however, it is still not purposeful
to shorten the liquidation below two weeks independent of the chosen strategy. High
dependence of the expected ToM from the assumed reservation price makes it very
difficult to compare the liquidity of property markets on the basis of this
measure. To illustrate this problem, ranges of liquidation times resulting for
rational sale strategies have been depicted in Figure 5-1. Not only the measured
ToM values but also the assessments of markets' relative liquidity are subject to
the assumed reservation prices.

473

Reservation prices applied in the computation of TOMmax and TOMmin are identical
with those used for the computation of the minimum and maximum receipts'
volatilities summarized in Table 5-6.
5.2 Condominium Liquidity Analysis

329

Only in extreme cases and only for high discounting factors some of the
condominiums are clearly more liquid than the others. For example, good-quality
condominiums in Stuttgart always have a shorter expected liquidation period than
respective condominiums in Frankfurt at =50%. In most cases, however, no such clear
cut relation can be observed. Hence, also with respect to this measure, no simple,
onedimensional delimitation of more and less liquid markets is possible. Contrary
to the opinion of Lippman/McCall (1986) who proposed the expected duration of
search as an economically well founded operational liquidity measure, it proves to
yields only vogue results when merely the maximization of expected receipts but not
the uncertainty about the outcome of the liquidation is taken into account.
330

Chapter 5: Liquidity of German Condominium Markets

4000 3500 Cologne G 3000 Cologne M Duisburg G

Expected ToM

2500 2000 1500 1000 500 0 1,21 1,33 1,45 1,57 1,69 1,81 1,93 2,05 2,17

Duisburg M Frankfurt G Frankfurt M Hanover G Hanover M Stuttgart G Stuttgart M

Reservation Price

=5%

200 180 160 140 Cologne G Cologne M Duisburg G Duisburg M Frankfurt G 100 80 60 40
20 0 1,16 1,23 1,30 1,37 1,44 1,51 1,58 1,65 1,72 1,79 Frankfurt M Hanover G
Hanover M Stuttgart G Stuttgart M

Expected ToM

120

Reservation Price

=25%
5.2 Condominium Liquidity Analysis

331

120

100

Cologne G Cologne M

Expected ToM

80

Duisburg G Duisburg M Frankfurt G

60

Frankfurt M Hanover G

40

Hanover M Stuttgart G Stuttgart M

20

0 1,08 1,15 1,22 1,29 1,36 1,43 1,50 1,57 1,64

Reservation Price

=50%

Figure 5-1: Expected ToM of selected German condominium markets (days)

5.2.2.4. Liquidity Risk


One of the main messages of this book is the necessity of including risk
considerations in the liquidity analysis, especially when highly illiquid assets
like real estate are considered. Hence, this section is devoted to the application
of several types of liquidity risk measures to the German condominium markets. In
the first place, the volatility of net sale receipts is computed for each
submarket. This measure is also central for the analysis in the following sections.
Additionally, two asymmetric risk measures are considered: default probability,
i.e., the probability of achieving a liquidation value below some target value, and
semivolatility of net liquidation receipts, i.e., the lower partial moment of grade
2. Formula (3.28) was used for computing volatility. Like in the case of the Quick
Sale Discount and the expected ToM, the results highly depend on the reservation
price assumed in the search model. Depending on investors' preferences, different
alternatives are feasible. While some investors may strive for high expected sale
outcomes, more risk-averse individuals may prefer to keep the risk low. Each group
would choose a different search strategy and obtain different values of the
receipts' volatility.
332

Chapter 5: Liquidity of German Condominium Markets

In order to allow for this fact, two extreme cases were analyzed on the one hand,
reservation prices minimizing the volatility of net sale receipts were used, on the
other hand, reservation prices maximizing the expected receipts were applied. These
two values can be considered as the upper and the lower limit for liquidity risk
involved under rational liquidation strategies. Furthermore, different grades of
time pressure were allowed for with discount rates ranging from 5% to 50%. The
results are summarizes in Table 5-6.
Table 5-6: Volatility of net receipts on selected German condominium markets
Frankfurt M Duisburg M Frankfurt G Duisburg G Hanover M Stuttgart M 0.08 1.32 1.97
1.65 0.08 1.31 0.12 1.43 0.08 1.28 0.10 1.38 Cologne M Hanover G Stuttgart G 0.07
1.28 0.99 1.55 0.08 1.26 0.10 1.35 0.08 1.21 0.10 1.30 Cologne G 0.14 1.48 1.41
1.94 0.14 1.46 0.20 1.65 0.14 1.41 0.18 1.56

all figures in %

Vmin ( = 5%) Reservation Prices Vmax ( = 5%) Reservation Prices Vmin ( = 25%)
Reservation Prices Vmax ( = 25%) Reservation Prices Vmin ( = 50%) Reservation
Prices Vmax ( = 50%) Reservation Prices

0.10 1.45 1.70 1.84 0.10 1.43 0.15 1.57 0.11 1.38 0.13 1.50

0.12 1.21 0.72 1.55 0.12 1.15 0.15 1.28 0.14 1.08 0.16 1.19

0.13 1.52 0.69 1.89 0.13 1.46 0.17 1.62 0.14 1.39 0.17 1.53

0.16 1.27 2.16 1.83 0.16 1.24 0.21 1.43 0.17 1.17 0.20 1.32

0.13 1.70 1.47 2.19 0.14 1.64 0.18 1.80 0.15 1.55 0.18 1.70

0.10 1.30 0.74 1.60 0.10 1.28 0.14 1.41 0.11 1.23 0.13 1.34

0.09 1.50 0.68 1.79 0.09 1.46 0.12 1.57 0.10 1.40 0.12 1.50

As it seems, the minimal volatility remains to a large extent unchanged for


different discounting factors, but the maximal volatility reacts much stronger to
the time pressure. Especially for low opportunity costs, the uncertainty associated
with the liquidation according to the reservation price maximizing expected net
receipts is far above the respective minimal value. The discrepancy is smaller when
higher discount rates are assumed. The conclusion can be drawn from this result
that the minimal volatility is a more robust measure of liquidity risk; it is less
sensitive to the investor's personal situation. Yet, in certain situations, e.g.,
for less risk-averse individuals acting under small time pressure, it may be only a
biased indicator of the true uncertainty. Attempt-
5.2 Condominium Liquidity Analysis

333

ing to increase the expected receipts from sale, such investors are likely to run
risks that are far above the minimum risk level. A methodical problem related to
the use of volatility or variance is the symmetric definition of risk implied by
these statistics. This may lead to a false interpretation of the chance of
achieving unexpectedly high receipts as undesired by the investor. In order to
control for this possible problem, two alternative asymmetric measures were
computed. Unfortunately, as discussed in section 3.3.3, there is no easy way of
determining these measures analytically; hence, a simulation-based estimation was
necessary. A liquidation scenario with parameters as they were applied in the
search model was set up and re-run 10,000 times. The structure of the simulation
corresponded with the one proposed in section 2.3.4. The distribution of randomly
generated net liquidation receipts was obtained as a result. Due to the large scope
of computations, no optimizing with respect to the reservation price could be
conducted; i.e., no minimum value for the default probability or semivolatility was
available. Instead, the volatility minimizing reservation price was used to
estimate the minimum values of the measures. Parallel, the reservation price
maximizing the expected net receipts was applied to obtain the maximum values.
While only negative deviations from the expected receipts were included in the
computation of semivolatility, the probability of default was additionally computed
with regard a fixed target value of 1, which corresponds with the average valuation
of condominiums on the market. The results are summarized in Table 5-7.
334

Chapter 5: Liquidity of German Condominium Markets

Table 5-7: Liquidity risk measures for selected German condominium markets
Frankfurt M Duisburg M Frankfurt G Duisburg G Hanover M Stuttgart M 4.7 57.3 33.3
0.0 59.5 3.8 0.0 61.0 3.9 0.0 61.3 4.0 0.0 61.0 4.0 0.0 60.3 4.4 Cologne M Hanover
G Stuttgart G 2.2 54.6 18.2 0.0 60.0 3.7 0.0 60.1 3.9 0.0 61.0 3.9 0.0 60.6 4.1 0.0
60.1 4.4 Cologne G 1.1 55.3 24.9 0.0 59.5 6.7 0.0 60.6 7.0

all figures in %

E() maximizing reservation price = 5% Def. Prob. (t=1) Def. Prob. (t=E())
Semivolatility Def. Prob. (t=1) Def. Prob. (t=E()) Semivolatility Def. Prob. (t=1)
Def. Prob. (t=E()) Semivolatility 1.9 57.3 27.2 0.0 60.7 5.0 0.0 60.8 5.2 3.8 51.1
24.3 0.1 58.1 6.5 0.3 57.6 7.2 0.2 54.0 14.8 0.0 60.3 6.7 0.0 60.3 7.0 11.2 55.2
67.8 0.0 57.7 8.4 0.0 58.2 8.6 0.8 53.7 28.4 0.0 61.3 6.8 0.0 60.8 7.2 0.7 54.2
14.6 0.0 60.1 4.9 0.0 59.5 5.0 0.1 54.9 11.2 0.0 60.9 4.4 0.0 60.7 4.6

= 50%

= 25%

V() minimizing reservation price = 5% Def. Prob. (t=1) Def. Prob. (t=E())
Semivolatility Def. Prob. (t=1) Def. Prob. (t=E()) Semivolatility Def. Prob. (t=1)
Def. Prob. (t=E()) Semivolatility 0.0 60.4 7.1 0.0 60.3 7.4 0.0 60.3 7.5 0.0 60.6
5.2 0.0 60.3 5.3 0.0 61.1 5.7 0.0 59.7 6.3 0.0 59.4 6.7 0.4 58.5 7.7 0.0 60.7 6.8
0.0 60.2 7.1 0.0 60.7 7.7 0.0 59.3 8.4 0.0 59.6 8.5 0.0 58.7 9.3 0.0 60.9 7.0 0.0
60.3 7.2 0.0 60.9 7.9 0.0 60.5 5.3 0.0 60.0 5.3 0.0 59.9 5.7 0.0 60.5 4.6 0.0 60.7
4.8 0.0 60.1 5.0

What strikes at first sight with respect to the default probability is that it only
rarely exceeds zero when a fixed target of 1 is set. In fact, only for E()
maximizing reservation prices and for the discount rate of 5% somewhat higher
values have been recorded. In other cases, it was almost certain that condominiums
would sell above their average valuations. However, the probability that net
receipts were below their expected values was significantly higher and lied at
about 60% in most cases. This result indicates clearly that the distribution of net
sale receipts is not only non-normal but also asymmetric the probability of lying
below the mean should be at about 50% otherwise. The fact that the relative
assessment of liquidity risk in the analyzed markets is

= 50%

= 25%
5.2 Condominium Liquidity Analysis

335

highly sensitive to the chosen target level of receipts and to the assumed
reservation prices and discounting factors is another important result. E.g., while
Frankfurt G could be classified as a highly (liquidity) risky market according to
the default probability with a fixed target at =5%, it was among the least risky
ones when E() was set as the target. The results of liquidity risk measurement with
semivolatility reinforce these conclusion ranks of the analyzed markets differ
from those arising from default probability, even when the latter is referred to
the expected sale receipts. This means that the liquidity risk of the condominium
markets is assessed differently by an investor who is only concerned about not
selling below the expectations than by an investor who also cares about how much
below the expectations she could sell. In view of the differences in the result
achieved with different liquidity measures, the question arises, which of them
allows the most precise measurement. The answer depends, of course, on the attitude
and the personal situation of the particular decision maker; however, some
objectively valid remarks are also possible. As argued in section 3.3.3, it is more
appropriate to assume that investors are averse only to underperforming the target
and also perceive risk this way. The superiority of the asymmetric measures follows
directly from this assumption. Furthermore, it seems also plausible that investors
are concerned about the scale of the underperformance and do not only differentiate
between achieving and missing the goal. Hence, higher grade Lower Partial Moments
should usually provide better results. It consequence, semivolatility should be
preferred to volatility and default probability. An additional argument against
volatility is the asymmetry of the receipts' distributions stated during the
simulation. However, a closer look reveals that the relative assessments of
liquidity risks with volatility and semivolatility is nearly identical. This can be
explained by the fact that the direction as well as the intensity of asymmetry is
very similar for all condominium markets. On the one hand, this is indicated by the
low variation of default probabilities computed with respect to expected receipts.
On the other hand, also the skewnesses of the respective receipts' distributions
obtained in the simulation did not deviate much from each other.474 This result
seems to restore the validity of receipts' volatility as a good liquidity risk
measure. Since it leads to a similar relative assessment
474

The skewnesses of the distributions of liquidation receipts for different markets


lied between 1.1 and 1.5 for receipts volatility minimizing reservation prices. The
dispersion was higher for expected receipts maximizing reservation prices and
discounting rates of 25% and 50% with skewnesses lying between 0.9 and 1.5; for the
discounting factor of 5%, the respective values varied more strongly between 0.1
and 1.2. For more detailed results see Appendix B.2.
336

Chapter 5: Liquidity of German Condominium Markets

of liquidity risk as the theoretically superior semivolatility and is


simultaneously much easier to handle in decision models, it is used in the
following sections. It should, however, be stressed that this conclusion refers
only to the analyzed condominium markets and does not necessarily need to hold in
the general case.

5.2.2.5. Liquidity Risk Reward


The Liquidity Risk Reward defined in section 3.4.1 is a very appealing measure,
which also seems to have a firm theoretical foundation. On the one hand, its
construction is very similar to that of the widely used and accepted Sharpe ratio.
In this sense, it can be interpreted as the unit price of liquidity risk. On the
other hand, the liquidation strategy (reservation price) that maximizes asset's LRR
can be considered as optimal for a wide group of investors. In particular, if not
only illiquid but also liquid assets can be sold in order to deal with a liquidity
shock, investors should always apply the LRR maximizing reservation price
independent of their attitude to liquidity risk. Individual preferences can be
allowed for by optimizing the proportions in which the liquid and the illiquid
asset are to be liquidated. Hence, LRR measures liquidity risk as the ability of an
asset to provide adequate receipts in relation to the liquidity risk involved in
the liquidation process in a broader context. The results of the application of LRR
to the German condominium markets are summarized in Table 5-8. The measure was
computed separately for three different discounting rates; in each case, only the
maximum values (with respect to the reservation price) are reported. Large
differences between the condominium markets in the measured levels of liquidity are
striking. While the ratio of the liquidation premium (i.e., the excess of the
expected net receipts over the average valuation of the condominium) to the
standard deviation of the receipts measured at a 5% discount rate is nearly 7 in
Hanover G, it lies only at about 3 in Frankfurt G. Since higher time pressure
reduces the reward for accepting liquidity risk, LRR values range between 1.3 and 5
for the discount rate of 50%. The relative assessment of the markets' liquidity
remains, however, unchanged.
5.2 Condominium Liquidity Analysis
Table 5-8: Liquidity Risk Reward of selected German condominium markets Frankfurt M
Duisburg M Frankfurt G Duisburg G Hanover M

337

all figures in %

LRR ( = 5%) Reservation Prices LRR ( = 25%) Reservation Prices LRR ( = 50%)
Reservation Prices

4.86 1.55 4.36 1.52 3.67 1.46

5.75 1.50 5.18 1.47 4.40 1.42

3.09 1.27 2.06 1.21 1.27 1.14

5.28 1.58 4.34 1.51 3.47 1.44

3.07 1.36 2.46 1.32 1.76 1.24

6.59 1.76 5.50 1.68 4.52 1.60

4.33 1.35 3.71 1.32 2.98 1.27

6.96 1.54 5.92 1.49 4.95 1.43

5.09 1.32 4.27 1.29 3.40 1.24

5.49 1.36 5.02 1.34 4.32 1.31

As already mentioned, the good theoretical foundation of the Liquidity Risk Reward
makes it an interesting liquidity measure for a variety of different investor types
in different situations. Still, one must bear in mind that it can be biased under
certain conditions. In the first place, as the underlying liquidity risk measure is
volatility, LRR may not perform well when the distributions of liquidation receipts
have significantly different skewnesses using semivolatility instead of
volatility could yield better results in this case. However, as demonstrated in the
previous section, this problem is not severe with respect to the analyzed
condominium markets. Another important point is the correct interpretation of the
measure. In particular, investor's preferences can be ignored only if a parallel
sale of a liquid asset is possible. Otherwise, if no liquid assets are available,
investor's risk attitude does not necessarily need to correspond with the inverse
relation assumed in the measure. For the same reason, LRR seems to be less suitable
for the planned liquidation, when a stand-alone sale is in focus. Thus, the values
computed for the discounting rates of 25% and 50% seem to be more meaningful.

5.2.2.6. Two-Dimensional Liquidity Assessment


The final approach to liquidity measurement, proposed in section 5.2.2.6, goes away
from expressing this quality with a single figure and regards marketability and
liquidity risk as separate components in a two-dimensional room. This procedure
does not ensure that unambiguous identification of more and less liquid asset is
always possible, but it allows for more robust conclusions. In particular, it is
possible to state which investments are definitely illiquid to any investor
independent of her preferences, and

Stuttgart M

Cologne M
Hanover G

Stuttgart G

Cologne G
338

Chapter 5: Liquidity of German Condominium Markets

which can be differently assessed by individuals with different levels of risk


aversion. The logic behind this approach complies with the main conclusion form the
considerations about the nature of liquidity in Chapter 1. According to it,
liquidity is not an absolute quality, and its level depends strongly on individual
preferences. Another advantage of this approach is its flexibility. It can be
easily adjusted to different measurement methods of marketability and liquidity
risk. Following the discussions in earlier Chapters, expected net receipts and
receipts' volatility are used in this section. However, it is also possible, though
more computation intensive, to apply other (e.g., asymmetric) liquidity risk
measures. The two-dimensional approach in this section is based on the graphical
analysis of E()-V()-loci resulting for efficient liquidation strategies. After
determining the range of reservation prices that lead to minimum liquidity risk at
the given level of marketability (or to maximum marketability at the given level of
liquidity risk) the respective expected net receipts and receipts' volatilities
have been plotted. They produce liquidity efficient frontiers specific for each
condominium market. The analysis has been repeated for discounting rates of 5%,
25%, and 50%. The results are depicted in Figure 5-2.
5.2 Condominium Liquidity Analysis

339

2,2 Cologne G

Expected Net Receipts

Cologne M Duisburg G Duisburg M

1,8

Frankfurt G Frankfurt M

1,6

Hanover G Hanover M Stuttgart G

1,4

Stuttgart M

1,2 0 0,5 1 1,5 2

Volatility of Net Receipts

=5%

1,9

1,8 Cologne G Cologne M Duisburg G 1,6 Duisburg M Frankfurt G 1,5 Frankfurt M


Hanover G Hanover M 1,4 Stuttgart G Stuttgart M 1,3

Expected Net Receipts

1,7

1,2 0,05 0,1 0,15 0,2 0,25

Volatility of Net Receipts

=25%
340

Chapter 5: Liquidity of German Condominium Markets

1,8 1,7 Cologne G 1,6 Cologne M Duisburg G 1,5 1,4 1,3 1,2 1,1 1 0,06 0,08 0,1 0,12
0,14 0,16 0,18 0,2 0,22 Duisburg M Frankfurt G Frankfurt M Hanover G Hanover M
Stuttgart G Stuttgart M

Expected Net Receipts

Volatility of Net Receipts

=50%

Figure 5-2: Two-dimensional liquidity measurement of selected German condominium


markets

The "lengths" of the efficient frontiers depend strongly on the discount rate and
become "shorter" with an increasing time pressure. Nevertheless, in each case, some
markets turn out to be "liquidity inefficient", i.e., they yield lower expected net
receipts at a higher liquidity risk than other markets. The "inefficient set"
consists of Cologne G and M, Duisburg G, Frankfurt G, and Hanover G in the scenario
with 5% discount rate, of Duisburg G, Frankfurt G, and Hanover G in the scenario
with 25% discount rate, and of Duisburg G and M, Frankfurt G, and Hanover G in the
scenario with 50% discount rate. Hence, certain markets, among them Frankfurt M,
Hanover M, and Stuttgart G and M are so superior with respect to their liquidity
characteristics that they are efficient in all analyzed scenarios. Apart from
determining the superior and inferior sets of condominium markets, the two-
dimensional approach also allows comparing pairs of investments. So, e.g., under
the assumption of a very high time pressure (=50%) a good quality condominium in
Duisburg can be considered as less liquid than a good condominium in Hanover;
however, their relation to good quality condominiums in Frankfurt is ambiguous and
can only be determined on the basis of preferences of a concrete investor.
5.2 Condominium Liquidity Analysis

341

The method applied in this section is unorthodox as it does not always allow
ranking the analyzed markets with respect to their liquidity. Although it was
possible to name objectively more liquid markets in some cases, ambiguousness still
remained in many other cases. However, as soon as investor's preferences between
marketability (expected liquidation receipts) and liquidity risk (receipts'
volatility) are formulated and quantified as indifference curves, the level of
utility associated with the liquidation of each property can be determined. It can
be then used as a subjective liquidity measure, as proposed in section 3.4.2, and
enables a strict identification of the most and the least liquid condominium
markets. Since such a measure would reflect not only the features of the specific
property market but also the individual attitude of the investor, it would only be
valid for this single investor. Because the analysis in this Chapter is not
addressed to any specific individual, this step has not been taken here.
Nevertheless, the preference-based two-dimensional method seems to be the most
appropriate approach to liquidity measurement.

5.2.2.7. Comparison of the Measures


The results of the liquidity analysis of German condominium markets presented in
the former sections were highly dependent on the applied measurement method. Hence,
the question arises in how far the choice of the method affects the conclusions
about the relative levels of liquidity on different markets. The discussion of the
relations between different measures in section 3.5 revealed that some connection
can be expected between most of the measures; it should, however, vary depending on
the aspect of the problem on which the focus it placed. In particular, measures of
liquidity risk may display only a weak relation to the more traditional measures of
marketability. Already a superficial analysis of the results in this Chapter
reveals that the matter is more complex the relations between the measures depend
also on the assumed environment of the decision maker, in particular, on the time
pressure. Thus, it is very difficult to identify the ultimate liquidity measure
that could be applied in any situation. This result is not surprising the
subjective character of liquidity has been already stated earlier in this book. In
practice, however, identification of the appropriate approach and the parameters on
which it should be based may prove very difficult. In particular, liquidity
analysis might need to be conducted without knowing the investor to whom it is
addressed this is the problem often faced by market researchers or the
parameters of the model might be uncertain. The latter difficulty is probable when
the liquidation is
342

Chapter 5: Liquidity of German Condominium Markets

expected to occur in the far future. In this context, it is highly relevant whether
and to what extent different measures lead to the same ranking of assets or markets
with respect to their liquidity. The relative liquidity of German condominium
markets resulting from the application of the seven different measures is presented
in Figure 5-3. Wherever several variants of a measure were computed, only one of
them has been chosen for better tractability. Thus, only the minimum liquidation
duration (ToM) is regarded, only liquidity risk measures resulting for volatility
minimizing reservation prices are considered, and the target for the default
probability is limited to expected net receipts. Furthermore, for better
comparability of the results, only the ranks of the markets resulting for different
measures are depicted. In this sense, 1 means the highest and 10 the lowest
liquidity rank; equal ranks are possible. Due to the impossibility of producing an
unambiguous ranking, the two-dimensional approach is omitted.
5.2 Condominium Liquidity Analysis

343
344

Chapter 5: Liquidity of German Condominium Markets

Figure 5-3: Ranks of selected German condominium markets with respect to their
liquidity according to different measurement approaches

The first impression from the comparison of rankings obtained on the basis of
different measures confirms the high dependence of the relative liquidity from the
applied approach. While some of the measures lead to contrary conclusions (e.g.,
the number of transactions and the Implicit Spread), others match fairly well
(e.g., the Implicit Spread and the Quick Sale Discount). In order to quantify these
differences, rank correlations according to Spearman (corrs) have been used. This
statistic can be interpreted similarly to the standard Bravais-Pearson correlation
coefficient (it ranges from -1 to 1) and is computed for observation vectors X and
Y as:475
6 (k X ,i - k Y ,i ) 2
i =1 n

corrS (X, Y ) = 1 - with: ki

n (n - 1)

(5.2)

- rank of the ith element

475

See Kendall (1962), p. 20 f., Hartung et al. (2002), pp. 553 ff., or any statistics
handbook.
5.2 Condominium Liquidity Analysis n - number of elements

345

The results are summarized in Table 5-9. The upper value in each cell refers to the
discounting rate of 5%, the middle value to 25%, and the lower value to 50%.
Table 5-9: Rank correlations between liquidity measures of selected German
condominium markets Receipts' Volatility Time on Market Def. Probability Implicit
Spread Liquidity Risk Reward 0.90 0.92 0.92 -0.39 -0.65 -0.71 -0.39 -0.65 -0.75
0.36 0.55 0.62 0.36 0.15 0.20 -0.65 -0.78 -0.68 0.42 0.22 0.32 1.00 1.00 1.00
Receipts' Semivolatility 0.56 0.54 0.64 0.59 0.53 0.27 0.59 0.53 0.20 0.68 0.76
0.90 0.99 0.98 0.98 -0.64 -0.56 -0.07 1.00 1.00 1.00 Number of Transactions

Number of Transactions

1.00 1.00 1.00

-0.25 -0.35 -0.43 1.00 1.00 1.00

-0.25 -0.35 -0.47 1.00 1.00 0.98 1.00 1.00 1.00

Quick Sale Discount

0.61 0.79 0.85 0.10 0.04 -0.01 0.10 0.04 -0.09 1.00 1.00 1.00

0.50 0.48 0.53 0.64 0.56 0.42 0.64 0.56 0.32 0.66 0.75 0.87 1.00 1.00 1.00

-0.66 -0.91 -0.55 0.07 0.25 0.81 0.07 0.25 0.75 -0.61 -0.76 -0.27 -0.61 -0.53 0.09
1.00 1.00 1.00

Implicit Spread

Quick Sale Discount

Time on Market

Receipts' Volatility

Def. Probability

Receipts' Semivolatility

Liquidity Risk Reward

The above comparison reveals that although different measures lead to different
rankings of the markets, they can be associated in several groups. One of such
groups encompasses the Implicit Spread and the Quick Sale Discount. This similarity
is not sur-
346

Chapter 5: Liquidity of German Condominium Markets

prising as the construction of these measures is based on the same principle


maximum expected net receipts from sale are central to both of them. The only
relevant difference is the additional inclusion of expected net expenditures at
purchase in the Spread. However, since both expected values are roughly symmetric
around the mean offer value of 1, the resulting differences in the rankings are
only marginal. In effect, both measures describe the liquidity of the respective
property markets, or equivalently, the situation of a passive investor, who does
not attempt a strategic liquidation and either trades with a (hypothetical) dealer,
or sells to the first interested buyer. The second group consists of volatility and
semivolatility of liquidation receipts. Also this result is in line with
expectations. As discussed earlier, both measures should yield consistent relative
assessments of liquidity if the underlying distributions of net receipts are
symmetric or the skewness is similar for the analyzed investments (markets).
Although asymmetry was present in the distributions generated in the Monte Carlo
Simulation in section 5.2.2.4, its level measured with the skewness coefficient was
similar for most markets. Hence, volatility and semivolatility seem to be
relatively good substitutes in the analyzed case. However, this does not hold for
the default probability which leads to partially opposite rankings of the markets
compared to the volatility measures. Thus, a decision maker concerned only about
not reaching a certain liquidation value may act against her own preferences if she
chooses volatility or semivolatility to measure liquidity risk. Analogically, an
investor concerned about not deviating much from the expectations about the outcome
of the liquidation will perform poorly by applying the default probability.
Somewhat surprising is the similarity stated between the rankings of markets
resulting from the application of the Liquidity Risk Reward and the number of
transactions. As noted earlier, the former measure is, in my opinion, most adequate
when subjective liquidity of an asset to an active investor following individually
optimized selling strategies is considered, and liquidity measurement needs to be
performed on the basis of a single ratio. Not only does it combine the expectation
and uncertainty dimensions of liquidity, but it also corresponds with the objective
optimal liquidation strategy in the most general case of an investor holding both
liquid and illiquid assets. In this light, it is astonishing that a measure as
simple as the average number of transactions observed on the market in the past
leads to nearly the same result as the much more elaborate Liquidity Risk Reward.
Yet, it is not clear whether this effect is due to the
5.2 Condominium Liquidity Analysis

347

actual similarity of the approaches or only the result of a more or less


coincidental combination of parameters for the analyzed markets. A more thorough
analysis would be necessary at this point. In contrast, the negative relation
between LRR and the Implicit Spread or QSD could be expected. As discussed in
sections 3.4.1and 3.5, high expected sale receipts (and low expenses) are a
positive feature when the investor is able and willing to perform a strategic
search, but they are a negative feature when she passively accepts the terms
dictated by the market. Thus, the difference between these measures is more
fundamental and arises from a different notion of liquidity. Summing up, it can be
stated that the choice of the method for liquidity measurement is crucial for the
quality of the decisions made on its basis. Although LRR and the two-dimensional
approach seem to be most adequate and have the best theoretical foundations,
investors who are concerned only about certain aspects of liquidity may achieve
better results using other approaches. In either case, however, the first step
should be a precise analysis of the actual goals of the concrete investor. The
quality of the measurement depends wholly on the correspondence between individual
preferences and the rationale behind the measurement approach. 5.2.3. Condominiums
in Portfolio Decisions

When a decision on a single investment is to be made, available alternatives need


to be compared with respect to their relevant characteristics, in particular, their
expected profitability, risk, and liquidity. In this context, the issue of
liquidity measurement becomes particularly important. The analysis of condominium
markets in selected German urban areas demonstrated how various measures derived in
Chapter 3 can be utilized for this purpose. However, investors often conduct more
than one investment simultaneously and are confronted with the problem of optimal
portfolio selection. Hence, the liquidity criterion needs to be considered not with
respect to a single investment but with respect to the whole portfolio. Combining
it with other criteria can (and in most cases will) lead to different results than
the traditional optimization techniques based solely on portfolio's expected
returns and return volatilities. The following two sections deal with changes in
the composition of optimal portfolios resulting from the introduction of a
liquidity goal based on the search theoretical considerations. German condominium
markets are used as the reference point and portfolios consisting of real estate
investments in these markets are considered. The main
348

Chapter 5: Liquidity of German Condominium Markets

purpose of the analysis is, however, not the formulation of a concrete investment
strategy but a demonstration how the notion of efficiency changes when the
portfolio selection model is extended to include the liquidity criterion. The
effects of a planned liquidation and possible liquidity problems in an emergency
case are considered separately. On the one hand, it turns out that the expected
profitability of a real estate portfolio increases rapidly when the possibility of
a strategic behavior during the planned liquidation is allowed for, but the level
of investment risk remains relatively unaffected. In effect, the efficient frontier
shifts upwards. On the other hand, the scope of feasible portfolios that can be
regarded as efficient and may be optimal for certain groups of investors widens
rapidly when the possibility of favorable liquidation in an emergency case is
included in the analysis.

5.2.3.1. Planned Liquidation, Return Characteristics, and the Efficient Frontier


As discussed in section 4.4.2.1, the fact that a liquidation strategy can be
applied at the end of the time horizon requires a correction of the return
statistics applied in the portfolio optimization. In particular, historical returns
of heterogeneous assets, which are usually based on average changes of market
prices, can be expected to underestimate both the profitability and the risk of
such investments. This effect is even more distinct when the purchase is also
subject to a random search process. In consequence, an investor following optimal
buying and selling strategies should be able to achieve higher returns than the
returns of an index based on average market valuations. On the other hand, also the
uncertainty about the realized returns experienced by the investor is higher than
the variability of the index returns it is increased by the uncertainty about the
outcome of the search process. Finally, due to the independency of different
searches, also the correlations between the returns of different assets should be
lower than the correlations between the respective index returns. These effects
lead not only to different assessments of the performances of different investment
alternatives but also to a shift in the efficient frontier. The extent of the shift
for investments in German condominiums is analyzed in this section. Since
considerations about changes in return characteristics of illiquid assets are only
purposeful in the case of a planned liquidation, only the discounting rate of 5% is
applied in this section. Furthermore, search effects during the purchasing process
are disregarded in order to keep the analysis tractable. Thus, return statistics
are corrected according to the formulas (4.23), (4.24), and (4.25), and the
purchasing price is as-
5.2 Condominium Liquidity Analysis

349

sumed to be on the level of the average market valuation (i.e., =1). Additionally,
a correction for the length of the holding period is necessary. The returns of the
condominium investments computed in section 5.2.1.3 are based on annual data. In
reality, however, engagements in such investments are much longer than one year.
Disregarding this fact would lead to a drastic overestimation of the true return
levels experiences by investors. Thus, the strategic liquidation effect needs to be
adjusted for the supposed holding period. A time horizon of 10 year is assumed in
the following analysis. According to this assumption, relative liquidation receipts
are adjusted as follows:

~ =1+

-1 Time Horizon

(5.3)

The key statistics of the liquidation receipts (expected values, standard


deviations, and covariances) are adjusted correspondingly.476 Another problematic
issue in the adjustment of market (index) returns for liquidation effects is the
choice of the adequate selling strategies. Since it depends on the preferences of
the decision maker, no definite answer can be given here. The following analysis is
therefore conducted for maximum and for minimum reservation prices to give a better
impression about the range of achievable results. Note, however, that while the
maximum expected return is achieved for the same set of reservation prices which
maximizes expected net receipts, reservation prices minimizing the return
volatility do not necessarily need to be the same as the prices minimizing
receipts' volatilities. Hence, the ranges of reservation prices that are rational
with respect to total returns from condominium investments differ from the ranges
resulting from sole liquidity considerations.477 The key statistics of the
corrected returns are summarized in Table 5-10.

476

477

Computation of the expected value of the corrected relative liquidation receipts is


trivial. It is also easily shown that the volatility (standard deviation) of the
receipts equals the original volatility divided by the time horizon, and the
correlation between receipts of two investments equals the original correlation
divided by the square product of the respective time horizons. As noted in section
4.4.2.1, the minimal return volatility results per definition for an infinitely
high reservation price, as the variability of net liquidation receipts is then
zero. This case, however, is not regarded here as it implies that the asset
(condominium) is not sold at all. Hence, only local minima of the receipts'
variances are considered.
350

Chapter 5: Liquidity of German Condominium Markets

Table 5-10: Characteristics of investment returns on selected German condominium


markets with optimal liquidation at the investment horizon Frankfurt M Duisburg M
Frankfurt G Duisburg G Hanover M Stuttgart M 8.3 21.1 1.65 15.0 31.7 0.24 8.3 21.2
Cologne M Hanover G Stuttgart G 6.7 13.0 1.55 12.4 17.4 0.63 6.8 13.2 Cologne G 7.3
17.2

all figures in %

Return Characteristics Without Liquidity Considerations Expected Return (%) Return


Volatility (%) 7.8 15.9 6.1 9.8 6.3 11.6 7.7 17.3 7.4 9.6 6.6 17.4 7.1 11.1

Liquidation Strategies Maximizing Expected Returns Reservation Price Expected


Return (%) Return Volatility (%) 1.94 16.9 23.5 1.84 16.5 24.5 1.55 11.7 12.8 1.89
15.3 14.9 1.83 16.3 32.2 2.19 19.7 19.4 1.60 12.7 20.1 1.79 15.1 14.1

Liquidation Strategies Minimizing Return Volatilities Reservation Price Expected


Return (%) Return Volatility (%) 0.36 7.5 17.5 0.46 7.9 16.2 0.78 6.8 10.0 0.69 7.3
12.0 0.36 7.8 17.6 0.88 9.7 10.1 0.38 6.6 17.6 0.72 7.7 11.4

The conclusions from the correction of market returns are twofold. On the one hand,
applying a sale strategy that maximizes the expected return (and simultaneously the
expected net sale receipts) led in all cases to a substantial increase of both the
expected profitability and the risk. On average, the expected return was higher by
about 10%points, and the return volatility nearly doubled in some cases (Frankfurt
G). On the other hand, the application of a reservation price that minimizes the
return volatility induced only marginal changes in the return characteristics of
the condominium markets. Hence, as it seems, average returns and risks experienced
by investors investing in German condominiums are higher than indicated by real
estate indices based on average market values; the extent of this effect depends,
however, on individual preferences. A similar effect occurs also with respect to
the covariances and correlations between the condominium markets' returns. While
they remain at a level similar to the original one when the reservation price is
set to minimize return volatility, they are much lower for reservation prices
maximizing expected returns. This fact is highly relevant for the optimal
structuring of portfolios consisting of condominiums in the selected markets.
5.2 Condominium Liquidity Analysis

351

Lower correlations indicate that a higher risk reduction due to diversification


should be possible. However, the position and the shape of the efficient frontier
depend eventually on all relevant return characteristics: expected returns, return
volatilities, and correlations. Taking this into account, two alternative efficient
frontiers are presented in Figure 5-4: one resulting from high reservation prices
maximizing the expected return and the other resulting from risk minimizing
reservation prices. For comparison, also the original efficient frontier without
strategic liquidation is depicted.

22% 20% 18%

Expected Return

16% 14% 12% 10% 8% 6% 0% 1% 2%

Strategic liquidation maximising expected returns Strategic liquidation minimising


return volatility (Frankfurt M excluded) Original efficient frontier

3%

4%

5%

Return Volatility

Figure 5-4: Efficient frontier with returns corrected for liquidation effects

The strong upward shift of the efficiency frontier in the scenario that assumes a
sale strategy which maximizes expected returns is striking, though not unexpected
in the light of changes in the return characteristics discussed above. While the
volatility range remained roughly similar, the expected returns have more than
doubled. In contrast, applying a search strategy that minimizes the return
volatility led to a smaller increase in expected returns but also narrowed the
volatility range. The latter effect was, however, mainly due to the high expected
return of the Frankfurt M market; in effect, it "crowded out" Stuttgart M from the
maximum return portfolio. Portfolio optimization without this market yielded an
efficient frontier that was nearly identical with the one obtained without
liquidity considerations.
352

Chapter 5: Liquidity of German Condominium Markets

Summing up, the main conclusion from the portfolio optimization based on returns
corrected for strategic liquidation at the end of the time horizon is the
improvement of the resulting efficient frontier. This means that higher returns can
be achieved at a lower risk. However, it also means that a different combination of
investments may be optimal for a specific investor. E.g., while an investment in
Stuttgart M is necessary to achieve high levels of expected returns in the original
portfolio selection framework, this market does not enter any efficient portfolio
in the extended scenarios unless Frankfurt M is excluded. In contrast, the
composition of the minimum variance portfolio for the original scenario and for the
scenario assuming risk minimizing liquidation is nearly identical. Hence, it seems
that the relevance of liquidity considerations for the allocation of capital on the
analyzed condominium markets decreases with the riskaversion of the investor. Since
risk minimizing reservation prices are low, the expected outcome of the liquidation
does not deviate much from the average market price level. However, for more
speculative investors, ready to accept higher risks, investments in German
condominiums seem to be much more attractive than it would follow from the analysis
of the respective market indices.

5.2.3.2. Portfolio Selection in a Multidimensional Decision Framework with


Liquidity Criterion
The final part of the liquidity analysis addresses possible changes in the
composition of the optimal portfolio compared to the traditional mean-variance
framework when liquidity is allowed for as an additional decision criterion. Three
alternatives are considered: in the first one, liquidity is captured with the
Implicit Spread, Liquidity Risk Reward is applied in the second one, and in the
third one, a four dimensional approach is followed with marketability (defined as
expected net receipts from liquidation) and liquidity risk (defined as volatility
of net receipts) included as separate criteria. Each of these approaches represents
a slightly different understanding of liquidity. Using the Spread implies that the
investor does not sell strategically, but accepts without bargaining the prices
that would be offered by a hypothetical risk neutral dealer. This is equivalent to
assuming that the investor is passive and takes market conditions as given. In
contrast, LRR and the two-dimensional approach are based on the assumption of a
strategically acting investor. The latter of the two approaches additionally allows
for any arbitrary preferences towards liquidity risk.
5.2 Condominium Liquidity Analysis

353

Since regarding liquidity as a dimension separate from market returns is only


purposeful in the case of an unexpected liquidation, the discounting rate is set at
25%; it corresponds with an investor selling under a moderate time pressure.
Furthermore, the correction of return statistics, as it was conducted in the former
section, is disregarded for better tractability of the results. Hence, the returns
of the condominium investments are assumed to be at the level suggested by the
IVD/RDM data. The inclusion of marketability and liquidity risk in portfolio
selection, either combined within one figure like the Implicit Spread or LRR or
considered separately, leads to a multidimensional optimization problem which is
not easy to solve analytically. It was therefore necessary to apply numerical
optimization. However, the amount of calculations in this approach increases
rapidly with the number of analyzed markets. The case of 10 condominium markets in
5 selected German urban areas proved to be too vast for the available software;
computations would still be possible, but they would take up to several months.
Since such effort would not be justified by the purpose of this Chapter intending
merely to demonstrate the practical application of the search theoretical approach,
the number of considered markets has been reduced to 5 only the markets for good
quality condominiums have been selected in each of the cities. The number of
explicitly identified efficient portfolios has been limited to about 500 for the
optimization with the Implicit Spread, to about 750 for the optimization with the
Liquidiy Risk Reward, and to about 3000 for the four-dimensional optimization with
expected net receipts and receipts' volatility. Another problem was the
presentation of the results. They encompass not only the expected returns and
return volatilities of the alternative (efficient) portfolios, as it is in the case
of the traditional MPT framework, but also one or two variables describing
liquidity. Hence, at least a three-dimensional chart would be necessary to depict
the efficient portfolios graphically. Yet, for better tractability and better
comparability of the results, a classical two-dimensional presentation has been
chosen. In this case, efficient portfolios form an area rather than a line; it
results from the projection of the efficient plane (or hyper-plane) on the two-
dimensional coordinate system.
354

Chapter 5: Liquidity of German Condominium Markets

The results of the optimization in the above described framework are presented in
Figure 5-5. In addition to the return- and liquidity-efficient area also the
original returnefficient frontier is depicted in each diagram.478

478

Note that the liquidity efficient portfolios are only selected points from a
continuous efficient hyperplane. Since the optimization was based on a limited MSC,
this selection is not necessarily fully representative. In particular, certain
regions (e.g., portfolios near the maximum expected return portfolio) are
underrepresented.
5.2 Condominium Liquidity Analysis
7,8%

355

a) Liquidity = Implicit Spread


7,6% 7,4%

Expected Return

7,2% 7,0% 6,8% 6,6% 6,4% 6,2% 6,0% 0,0% Liquidity Efficient Portfolios Original
Efficient Frontier 0,5% 1,0% 1,5% 2,0% 2,5% 3,0% 3,5%

Return Volatility

7,8%

b) Liquidity = Liquidity Risk Reward


7,6% 7,4%

Expected Return

7,2% 7,0% 6,8% 6,6% 6,4% 6,2% 6,0% 0,0% Liquidity Efficient Portfolios Original
Efficient Frontier 0,5% 1,0% 1,5% 2,0% 2,5% 3,0% 3,5%

Return Volatility
356
7,8%

Chapter 5: Liquidity of German Condominium Markets

c) Liquidity = Exp. Receipts and Receipts' Volaility


7,6% 7,4%

Expected Return

7,2% 7,0% 6,8% 6,6% 6,4% 6,2% 6,0% 0,0% Liquidity Efficient Portfolios Original
Efficient Frontier 0,5% 1,0% 1,5% 2,0% 2,5% 3,0% 3,5%

Return Volatility

Figure 5-5: Efficient frontiers with separate liquidity criteria: Implicit Spread
(a), LRR (b), and expected net receipts and receipts' volatility (c)

It is immediately apparent that the scope of efficient portfolios is much larger


when a liquidity criterion is allowed for. This means that portfolios which would
be considered highly inefficient if the optimization was conducted only on the
basis of index returns may turn out to be efficient when liquidity is taken into
account. Such portfolios offer superior chances of advantageous liquidation in case
of a liquidity bottleneck, and this compensates for their possibly inferior return
characteristics. E.g., a portfolio consisting of condominiums in Cologne, Duisburg,
Frankfurt, Hanover, and Stuttgart in proportions: 10.8%, 33.9%, 9.9%, 14.4%, and
31%, respectively (weights are rounded) offers the same expected return of about
5.6% as a portfolio with 20.3%, 10.7%, 9.6%, 23.5%, and 35.8% invested in the
respective cities but at a lower return volatility of only 0.7% instead of 0.8%;.
However, the latter portfolio offers a higher LRR of 7.8 instead of 6.3 in case of
a forced liquidation. Thus, both portfolios are efficient, and it depends solely on
investor's preferences which of them should be preferred. Clearly, each of the
three presented approaches leads to a different efficient area and a different set
of efficient portfolios. Moreover, since "portfolios" are here defined not
5.3 Discussion of the Results

357

only in terms of portions of capital invested in different markets but also


encompass reservation prices applicable in an unexpected liquidation, the
differences refer also to this aspect. This fact makes is difficult to state which
investments are actually to be considered efficient. The answer depends on the
appropriateness of the applied liquidity measurement concept in the concrete case.
The interpretations and the fields of application of the measures have been
discussed extensively in Chapter 3 as well as in section 5.2.2 earlier in this
Chapter. The Implicit Spread can be of interest only to absolutely risk-neutral
investors that are rather rare in the real estate branch. In contrast, optimization
with the LRR criterion is eligible to a wide group of liquidity risk-averse
investors holding both liquid and illiquid assets. Most universal, but also most
difficult to implement, is the optimization in the four-dimensional framework with
marketability and liquidity risk considered separately.

5.3.

Discussion of the Results

The practical application of the search theory to the measurement and management of
liquidity undertook in this Chapter is novel and requires a critical discussion. In
particular, it has to be cleared to which extent these results can be considered as
realistic and practically relevant. Can an investor deciding on the allocation of
her limited funds in one or more of the analyzed condominium markets draw valuable
conclusions from the estimation of various liquidity measures and the analysis of
portfolio efficiency performed on the basis of the search theoretical approach, or
is it only a purely theoretical concept? To answer this question, it is useful to
confront the results with the observed behavior of market participants and consider
if the implications are in line with common sense. In the first place, the validity
of the results is highly dependent on the quality of parameter estimation. As
already discussed in section 5.2.1, the determination of model parameters from
publicly available data is highly problematic, particularly with respect to the
dispersion of valuations and the arrival frequency of offers. The former parameter
has been estimated in this Chapter on the basis of the observed dispersion of
condominium transaction prices. As already noted, this is only an imperfect proxy.
On the one hand, condominiums in the samples are similar but not identical. This
means that the variability of transaction prices is not only due to different
valuations by market participants but also due to differences in the
characteristics of the condominiums. Thus, the standard deviations of offers used
in this model are probably overestimated.
358

Chapter 5: Liquidity of German Condominium Markets

On the other hand, each transaction price arises from (at least) two valuations:
that by the seller and that by the buyer. Hence, the prices should vary less than
the valuations themselves. This may to some extent mitigate the supposed
overestimation of the offer volatility. Another issue is the accuracy of the
estimated offer arrival frequencies. For the lack of a better method, they have
been derived from the trading intensity observed on the markets. This was, however,
a rather intuitive "guess" and not a strict estimation, so that inaccuracy can be
very high here. Nevertheless, the levels of the figures seem not entirely
unrealistic, as confirmed by several real estate dealers. The first remarkable
result has been obtained in the computation of the Implicit Spreads. The
reservation prices maximizing this measure proved to be extremely high and so were
the values of the measure itself. On the one hand, the optimal purchasing strategy
implied that condominiums should be bought far below the average valuation in the
extreme case of Frankfurt M even at a negative price. On the other hand, optimal
sale was to be conducted at prices as high as the double of the average. No such
behavior, not even anything in its proximity, can be observed on residential real
estate markets. A conclusion that it would be possible to realize an expected
spread of up to 200% of the fair value is therefore clearly misleading. In fact,
these results may be too high due to the overestimation of the offer volatility and
the offer arrival frequency mentioned earlier. Reducing the former parameter by a
half with respect to all submarkets would result in Implicit Spreads between 0.5
and 1.3 (about half of the original values). Yet, even these values are
unrealistically high. The actual source of the problem seems to lie in the risk
neutrality implied in the Spread. Such attitude is seldom, if ever, met among real
estate investors. The sole maximization of expected expenditures or receipts is
only a hypothetical concept, which leads to levels of liquidity risk that are
evidently unacceptable to any investor. Hence, there is only a limited possibility
of a meaningful interpretation of this measure with respect to real situations.
Same applies to other measures computed under the assumption that reservation
prices are set to maximize expected receipts. Also the respective values of the
Quick Sale Discount or the Time on the Market were unrealistically high in the
analogous cases; the latter reached selling durations of several years. In
contrast, the results obtained for reservation prices minimizing the volatility of
sale receipts were much more realistic e.g., the ToM could be measured in weeks
instead of years. A similar effect can be expected with respect to liquidity risk
measures, though it is not easily verified on the basis of empirical data.
5.3 Discussion of the Results

359

Summing up, the unrealistic results achieved for different reservation prices
indicate that the risk attitude of condominium investors is far from neutrality and
much closer to high levels of liquidity risk aversion. This may be due to the fact
that German residential real estate is generally considered to be a low risk
investment, but also due to the fact that much of the trade is consumption and not
investment driven. The consequences for liquidity measurement in these markets are
twofold. On the one hand, measurement based on maximizing the value of search does
not seem to be appropriate; measures based on risk minimizing reservation prices
can be expected to perform better. On the other hand, liquidity risk is of high
importance, so that omitting it can lead to a false picture of the markets.
Measures combining marketability and liquidity risk are therefore preferable. This
conclusion favors the Liquidity Risk Reward and the two-dimensional approach,
though the former seems easier to implement due to its brevity. According to it,
Hanover M, Frankfurt M, Cologne M should be considered most liquid, while Duisburg
G and Frankfurt G least liquid.479 However, it must be once again stressed that
this conclusion is subject to individual preferences of the decision maker. In this
sense, the results achieved in this Chapter cannot be generalized in terms of
suggesting an objectively optimal liquidation strategy. It is also not possible to
state on this basis which of the markets are objectively more or less liquid. The
differences resulting from the application of different reservation prices and
different discount rates make it clear that liquidity is a highly subjective
quality and can be experienced differently by different investors. However, as soon
as the preferences of the individual investor are adequately allowed for, search
theory based measurement can provide very detailed analysis of investors' situation
in the case of planned or forced liquidation of an asset. Another remarkable result
that requires a more detailed discussion is the effect of introducing search
theoretical liquidity considerations into portfolio optimization. In the first
place, allowing for strategic liquidation at the end of the investment horizon
resulted in increased expected returns without a significant increase of investment
risk. The effect depended strongly on the assumed strategy and, similarly as in the
above discussed case of liquidity measurement, was unrealistically strong when
reservation

479

Note that the most liquid markets have simultaneously low estimated dispersion of
offers, high frequency of offers, and low market uncertainty; in contrast, the
least liquid markets are those with the (by far) lowest offer arrival frequencies.
This result complies with the theoretical considerations about sources of liquidity
in Chapter 1.
360

Chapter 5: Liquidity of German Condominium Markets

prices maximizing expected net receipts were assumed. Hence, also in this case, it
seems that high (liquidity) risk aversion and, thus, the application of liquidity
risk minimizing strategies is more appropriate. Even in this case, however, there
was a clear upward shift of the efficient frontier for condominium portfolios. In
consequence, the analyzed condominium investments have proven to be more attractive
than it would follow from the pure index analysis. The robustness of this effect
was not explicitly tested here. Should it, however, be of more general nature, it
could provide a plausible explanation to the puzzle stated, e.g., by Giliberto
(1992) who came to the conclusion that returns of real estate indices are not
sufficient to justify the inclusion of this asset class in investment
portfolios.480 It seems conceivable that, at least for certain groups of investors,
the possibility of strategic liquidation leads to more favorable characteristics of
real estate portfolios than indicated by aggregated data.481 Finally, a comment is
necessary on the widening of the scope of efficient portfolios resulting from the
optimization with a liquidity criterion compared to the traditional Markowitz mean-
variance approach. Also here, the results differ depending on the assumed approach;
yet, in each case numerous portfolios, which would be inefficient in the standard
framework, become efficient due to their favorable liquidity characteristics. This
is especially apparent in the most general, four-dimensional approach with
marketability and liquidity risk treated as separate criteria portfolios with
expected returns below the level of the original Minimum Variance Portfolio and
risks above the original Maximum Return Portfolio were still among the efficient
ones. This striking result may be an explanation why certain real estate markets,
despite their poor performance, still enter investment portfolios in higher
proportions than suggested by the analysis of their past returns. It might be
advantageous for certain investors to hold a part of their capital in less
profitable and/or riskier assets, which, however, can be liquidated at a good value
with little uncertainty in case of an unexpected liquidity bot-

480

481

Also the results of other researchers confirm this puzzle. Fogler (1984),
Firstenberg et al. (1988), or Kallberg et al. (1996) assess the optimal allocation
of capital to real estate at about 10%-20%. This is less than the total share of
this asset in the investable wealth estimated by Ibbotson/Siegel (1983) at over 25%
and far less than the overall share of real estate in world's wealth (see section
1.3.2 in Chapter 1). Validation of this hypothesis should be possible by comparing
returns achieved by institutional investors on concrete properties with index
returns. An indication that the former might be higher is given by the relatively
high returns of real estate companies (REITs) compared to the returns of direct
real estate market indices. See, e.g., Geltner/Kluger (1998), Geltner/Rodriquez
(1998), or Pagliari et al. (2005).
5.3 Discussion of the Results

361

tleneck. Sacrificing a part of potential returns can be viewed as an "insurance"


against solvency problems. In this context, higher expected performance of
portfolios lying on the original mean-variance efficient frontier compared to that
of the "liquidityefficient" portfolios can be interpreted as a premium paid for
their inferior liquidity characteristics. *** As already stated at the beginning of
this Chapter, its main goal was not the analysis of concrete condominium markets
but rather a demonstration of the search theoretical concepts developed in earlier
Chapters and the analysis of the practical problems arising in the course of their
application. With respect to the former point, methods of model parameter
estimation have been discussed and computation routines set up in a popular MS
Excel framework. The application to German condominium markets was accomplished as
far as the available data and software allowed it. Yet, it is clear that much more
precise results could be achieved with means available to professional,
institutional investors. While it was not possible to estimate all model parameters
with maximal precision (e.g., the offer arrival rate could be assessed only very
roughly), this problem can be largely overcome by using large real estate databanks
and relying on longer investment experience in the relevant markets. Also the
limitations arising from the computation power are not a serious obstacle for a
large investment company. Hence, the methodology proposed in this book is not only
a pure theory and can be implemented in investment decisions on real estate and
other illiquid assets.
Concluding remarks

The initial impulse for the choice of the subject for this work was the discussion
about the applicability of the existing risk measurement and portfolio management
methods to real estate.482 In turns out that the main difficulty with this asset
class is the lack of perfect liquidity, which is required by most capital market
theories. While researchers generally agree that this issue is of high importance,
there is surprisingly little related literature; operational approaches that could
help investors to improve their decision quality are practically absent. The
ambitious goal of this book was, thus, to propose a way of coping with the
illiquidity problem. Moreover, it should not only remain a theoretical concept
based on non-measurable features but also have a potential of practical
implementation in the future. Preferably, it should also be compatible with the
existing decision frameworks, like the mean-variance approach to portfolio
optimization. In the light of the enormous complexity of the problem, a methodical
approach was needed that would allow capturing the full scope of liquidity within
one consistent and easily handled model. The solution was provided by the
mathematical apparatus of the Theory of Search. This approach, suggested already by
Lippman/McCall (1986), proved to be most promising for coping with problems
encountered when liquidating privately traded assets. The main goal of the analysis
was, thus, to translate and, if needed, to amend the search theoretical methodology
for modeling liquidation processes. I believe that the resulting approach is unique
and novel in a number of different aspects. The first Chapter of the book
demonstrates how complex the issue of liquidity actually is. The simple definition
referring to it as the "ease to sell" turns out to be insufficient for any
operational implementation of the liquidity criterion in investment decisions. The
analysis led to the identification of its two distinctly different dimensions: the
first one refers to the expected outcome of liquidation and has been denoted after
Hicks (1962) as marketability; the second one refers to the uncertainty about the
liquidation outcome and has been denoted as liquidity risk. Moreover, it seems that
the notion of liquidity can be also extended to the purchase of assets as a similar
problem arises then. In the course of the analysis, a number of sources of the so
defined liquidity have
482

See, e.g., Draper/Findlay (1982) or Jandura (2003), pp. 59 ff.


364

Concluding remarks

been identified, a review of assets most severely affected by this problem was
provided, and its major economic consequences were discussed. In total, the Chapter
offers an extensive presentation of the subject, which (to my best knowledge) has
been only rarely, if at all, presented in the literature in this scope. The
development of a search theoretical model of the liquidation process is in the hub
of Chapter 2. Although a lot of literature is devoted to the solutions of analogue
search problems, only a handful of papers contain references to liquidity. On the
one hand, the Chapter provides a fully specified model of the selling process for
property investments; on the other hand, it proposes a number of possible
improvements and enhancements to the model. The analytical derivations of the
variance (volatility) of net sale receipts and the covariance (correlation) between
receipts from selling different assets are of particular novelty. Although they are
presented in later chapters, they can be considered as amendments to the model from
Chapter 2. The result is a unique, coherent framework allowing the analysis of the
liquidation process under different environments and different selling strategies.
Moreover, its parameters can be interpreted as observable characteristics of assets
and markets, what makes it eligible for practical applications. Chapter 3 is
devoted to the development of concrete propositions for quantifying liquidity. A
large spectrum of alternatives based on different understandings of the problem and
different attitudes of investors have been reviewed. On the one hand, they are
based on already existing approaches, which were modified to fit in the search
theoretical framework. On the other hand, several new approaches have also been
proposed. Among them are measures of liquidity risk as well as measures
encompassing both marketability and liquidity risk. Especially the latter offer, in
my opinion, the most adequate description of the problem. In contrast to the
majority of existing measures, which concentrate on the marketability aspect only,
they allow for the fact that the outcome of the sale (or purchase) process on
illiquid private markets cannot be assumed as certain. However, regarding liquidity
as a two-dimensional phenomenon leads to the dependence of the measurement result
on the preferences of the investor. In effect, no absolute assessment of this
feature is possible. This result is in line with the conclusions from Chapter 1
stating that liquidity is a highly subjective characteristic of assets and markets.
Concluding remarks

365

While only quantification of liquidity has been addressed in Chapter 3, the


possibility of influencing it is considered in Chapter 4. One of the conclusions
from the search theoretical analysis of the sale process is its dependence on the
chosen search strategy, which is defined in terms of a reservation price. By
altering the reservation price, both the expected outcome of the process and its
uncertainty can be influenced to some extent. This means that liquidity is not an
intrinsic feature of assets but can be subject to individual decisions. This
conclusion has important consequences for investors willing to optimize the
execution of investments and the allocation of capital. Firstly, liquidation
strategies for assets held by an investor can be adjusted so that the liquidity of
her total holdings rather than the liquidity of single assets is optimized. This is
especially relevant when unexpected solvency problems are to be minimized. On the
other hand, liquidity can be considered in asset allocation decisions not only as
an additional decision criterion but also as a strategically adjustable feature.
Hence, portfolios containing illiquid assets can be optimized not only with respect
to assets' weights but also with respect to liquidation strategies assigned to
them. This extension of the classical portfolio selection model introduces a new
dimension to investment decisions on illiquid assets. According to it, these
investments offer more "degrees of freedom" in optimizing investment portfolios
than stocks and other highly liquid assets. Summing up, this work offers, as I
believe, the first coherent framework for analyzing, modeling, and managing
problems associated with investing in relatively rarely traded private assets like
real estate. The source of its novelty is twofold: firstly, it is the recognition
of the complex, multifaceted nature of liquidity and the role of search in this
respect; secondly, it is the application of the Theory of Search for liquidity
analysis. The developed model contributes to better understanding of the processes
occurring during the liquidation of an illiquid asset. Moreover, it can be
implemented in practice to improve the quality of investment decisions. The latter
point is of particular importance in view of the initial goal of the analysis,
which, as stated in the introduction, was to provide an operational approach to
liquidity. The analysis of German condominium markets in Chapter 5 demonstrated
that the methods proposed in this work can be applied even on the basis of publicly
available information. However, due to the high requirements regarding the quality
of data and the computation power, the approach is addressed mainly to
institutional investors.
366

Concluding remarks

Concluding the results, an outlook for further research in this field can be given.
In the first place, the proposed methods can be refined. The search model can be
extended following the propositions in Chapter 2, and analytical solutions for
further statistics can be derived. Another issue that deserves a more detailed
investigation is the impact of the characteristics of assets and markets as well as
the attitude of the decision maker on the results of the liquidity analysis. In
particular, the sensitivity of the results to various errors and misspecifications
may be of high practical relevance. A different field for further research is the
empirical validation of certain statements made on the basis of the search model.
This refers, e.g., to the behavior of market participants in illiquid markets, to
the possibilities of "beating the average" on the basis of optimized liquidation
strategies, or to the role of liquidity risk and liquidity risk aversion. Finally,
also other applications of the search model are conceivable including pricing of
illiquid assets and equilibrium analysis in illiquid private markets. Hence,
although the approach presented in this book is relatively mature and offers
solutions to numerous problems associated with imperfect liquidity, it can also
serve as a starting point for further research in several directions.
Appendix A

A.1.

Unique Solution of the Standard Search Problem

It is to prove under what conditions the following equation has a unique root in
p*: p* - p * F(p*) - p dF(p) = 0 p*

(A.1)

Define the function H(p*) as the left hand-side of the above equation and calculate
its derivate: dH(p*) 1 1 = - p * dF(p*) - F(p*) + p * dF(p*) = - F(p*) dp * Since
F(p*)(0;1), the derivate of H(p*) is always positive for < 1. Further, it holds
that: (A.2)

p*-

lim H (p*) = lim

p* - lim p * F(p*) - lim p dF(p) p*- p*- p*- p*

(A.3)

1 = lim p * -0 - E (P) = - p*- and lim H (p*) = lim p* 1 - lim p * F(p*) - lim p
dF(p) = lim p * - lim p * -0 p* p* p* p* p* p*

p*

(A.4)

Thus, the limit of H(p*) for p* approaching + is positive when < 1.


Recapitulating, function H(p*) is strictly increasing for < 1 the, it is negative
for small values of p*, and it is positive for large p*. The equation (A.1) has a
unique solution in this case.
368

Appendix A

For 1 H(p*) has a single global maximum at which F(p*) = 1/. By substituting for
F(p*) one receives the function's maximal value, which is:
H (p*) = p* p* p* - p * F(p*) - p dF(p) = - - p dF(p) = - p dF(p) < 0 p*
p* p*

(A.5)

Since the maximum and both limits of H(p*) are negative for 1, no solution to
(A.1) exists in this case. This accomplishes the proof.

A.2.

Closed Form Solution for Expected et Sale Receipts and Expected et Purchase Expense

A closed form formula for expected net receipts is to derive:


j ( - ) Tj ( - ) Tj j j E() = E (1 + A Tj )e + Tj e > * j j k =1
i i i i ( - ) t j ( - ) t kj j=1 j=1 = ... i (1 + a t j ) e +
tj e i =1 - 0 j=1 j=1 0 - i i Pr( i = i i > *) (1 - FR (*)) FR-1 ( *)
di dFT ( t j ) dFA (a ) j=1

(A.6)

Integrating over i yields: E() = ... i =1 0 0 -


i -1 R
i i i i ( - ) t j ( - ) t kj j=1 j=1 E( > *) (1 + a t ) e + tj e j
j=1 j=1

(A.7)

(1 - FR (*)) F (*) dFT ( t j ) dFA (a ) j=1


i

Integrating over a and applying the assumption that E(A) = 0 yields:


E() = ... i =1 0 0
i i i ( - ) t j ( - ) t kj j=1 j=1 E( > *) e + t j e j=1

(A.8)

(1 - FR (*)) F (*) dFT ( t j ) j=1


i -1 R i
Appendix A Finally, assuming exponential distribution of t1 to ti and integrating
yields:
E() = ... i =1 0 0 j i i E( > *) e t ( -) + t j e t j=1 j=1 k
=1
j j

369

( - )

(A.9)

i t i (1 - FR (*)) FR-1 (*) e dt j j=1 i j-1 i = E( > *)


+ ( + - ) 2 + - i =1 + - j=1

i (1 - FR (*)) FR-1 (*)

Consider both addends separately. The sum in the first addend is clearly a sum of
an infinite geometric series, so the expression can be rewritten as follows:
FR ( *) Add1 = E( > *) (1 - FR ( *) ) + - +- i =1
( + - ) = E( > *) + - (1 - FR ( *) ) - + (1 - F ( *) ) R
i -1

(A.10)

E( > *) (1 - FR ( *) ) - + (1 - FR ( *))

In the second addend the interior sum is a sum of a finite geometric series, hence:
j-1 i i (1 - FR ( *) ) FR-1 ( *) Add 2 = 2 i =1 ( + - ) j=1 +
- i 1- +- i = (1 - FR ( *) ) FR-1 ( *) 2 i =1 ( + - )
1- +- i (1 - FR ( *) ) i -1 = FR ( *) 1 - + - i =1 (
+ - ) ( - )

(A.11)

i -1 F ( *) (1 - FR ( *) ) i -1 FR ( *) - R ( + - ) ( - ) i
=1 + - i =1 + -
370

Appendix A

The expressions under both sums in Add2 are again infinite geometric series.

(1 - FR ( *) ) 1 1 - Add 2 = ( + - ) ( - ) 1 - FR ( *) + - - FR
( *) 1 +- = = (1 - FR ( *) ) 1 - ( + - ) ( - ) 1 - FR ( *) - +
(1 - FR ( *)) (A.12)

( + - ) ( - + (1 - FR ( *) )

The sum of both addends yields the simplified formula for E():
E ( ) = = E( > *) (1 - FR (*)) - + (1 - FR (*)) + ( + - ) ( - + (1 -
FR (*)))

E( > *) (1 - FR (*)) + - + (1 - FR ( *)) + -

(A.13)

Alternatively, it can be denoted as:

E () =

E( > *) X1 (1 - FR (*)) + Y1 1 - X1 FR (*) +- and Y1 =

(A.14)

with: X1 =

( + - )2

Finally, assuming that offers () are normally distributed yields:

E ( ) =

* -1 * -1 (A.15) 1 - + + * -1 + - - + 1 -

The respective formula for the expected net expense can be derived analogically.
Noting that an offer is accepted if it is below (and not above) the reservation
price and conducting analogical derivations yields the following result (appraisal
costs are netted with rental revenues):
Appendix A

371

E ( ) =

* -1 * -1 - X + + - * -1 X X - + X

(A.16)

A.3.

Unique Maximum of Expected et Sale Receipts

It is to prove that E() defined as:

E () =

E( > *) (1 - FR ( *)) + - + (1 - FR (*)) + -

= dFR () + - + (1 - FR (*)) * + - possesses a unique global


maximum with respect * when < . Computing the derivative of E() with respect to *
yields:
f R (*) dE() = d * ( - + (1 - FR (*))2 dFR () + - ( - + (1 - FR
(*)) * +- * with: fR(x) = dFR(x)/dx

(A.17)

(A.18)

Since < by assumption, the sign of dE()/d* is the same as the sign of the
expression in brackets. It is therefore sufficient to consider the latter one only,
which is denoted as H(*): H (*) = dF() +
*

- ( - + (1 - FR (*))) * +-

(A.19)

Since all expressions apart from *, including the integral, are limited and always
positive, the derivative of H(*) approaches minus infinity for high (positive)
values of * and plus infinity for low (negative) values of *. Furthermore, the
derivative of H(*) with respect to * equals:
372

Appendix A

dH(*) = -( - + (1 - FR (*))) d * and is strictly negative.

(A.20)

Recapitulating, H(*) is positive for low values of *, negative for high values of
*, and strictly decreasing. This indicates that H(*) has a unique root (zero) in
which it changes from positive to negative values. Obviously, same applies to
dE() /d*. It follows that E() increases for low *, decreases for high *, and
possesses a unique maximum. This accomplishes the proof.

A.4.

Conditional Expected Values

A.4.1. Conditional Expected Offer The conditional expected offer under normal
distribution of offers is to be computed:

E(P P > p*) =

p*

p dF(p)
1 - F(p*) (A.21)

Consider the integral expression substituting normal distribution density function


for F:
- 1 p 2 e ~ p*

( p- )2 2 2

dp dp -
p* ( p- )2 2
2

= p
p*

- 1 ~ e 2

( p- )2 2 2

- 1 ~ e 2

( p- )2 2 2

dp +
p* ( p- )2 2
2
- 1 ~ e 2

( p- )2 2 2

dp (A.22)

- 1 = ( p - ) ~ e 2 p*

- 1 dp + ~ e 2 p*

dp
( p - )2 2 2

- ( p - ) 1 = - - 2 ~ e 2 p*

( p - )2 2 2

- 1 dp + ~ e 2 p*

dp

Substituting with y = - (p-)/2 and noticing that dy = - (p-)/dp yields:


Appendix A

373
( p - ) 2 2 2
-

(p*- )2

p*

1 ~ e 2

dp = 2
( p*- )2
2

- 1 1 y ~ e dy + ~ e 2 p* 2 - 1 ~ e 2

( p - ) 2 22

dp

= 2
2

1 y ~ e 2

[ ]

( p - ) 2 2 2

dp

(A.23)

p*
- 1 = ~ e 2

(p*- )2
2

p*

- 1 ~ e 2

( p - ) 2 2 2

dp = (1 - F(p*)) + 2 f ( p*)

Defining (p) and (p) as standard normal density and standard normal distribution
functions, respectively, yields finally: E(P P > p*) = (1 - F(p*)) + 2 f (p*) f
(p*) = + 2 (1 - F(p*)) (1 - F(p*))

p * - p * - = + 1 -

(A.24)

For the relative version of the model the conditional relative offer is computed by
the division of E(P|P>p*) by : E( > *) = 1 + 2 f R (*) * -1 * -1 = 1 +
1 - (A.25)

(1 - FR (*))

with FR() and fR() being the relative offers' normal density and normal
distribution functions. A.4.2. Conditional Expected Square Offer The conditional
expected square offer under normal distribution of offers is to be computed:

E(P P > p*) =


2

p*

dF(p) (A.26)

1 - F(p*)

Consider the integral expression substituting normal distribution density function


for F. Define functions x(p) and y(p) as follows:
374 x ( p) = y( p) = p
- 1 ~ e 2

Appendix A
( p - ) 2 2 2

x (p) = - y(p) = 1

( p - ) - ~ e 2 3

( p - ) 2 2 2

(A.27)

According to the principle of integration by parts, the following equation holds


for the above functions: - 1 2 p 2 p*
- 1 ~ e 2

( p - ) 2 2 2

dp +

- 1 p 2 ~ 3e p* 2

( p- ) 2 2 2

dp

( p - ) - = - p ~ e 2 3 p*

( p- ) 2 2 2

dp

= x (p) y(p) dp = x (p) y(p) - x ( p) y( p) dp


p* p* ( p - ) 2 ( p - ) 2 - - 1 1 2 2 e 2 - e 2 dp = p ~ ~ 2 2 * p*

(A.28)

= -p *

- 1 ~ e 2

( p*- ) 2 22

p*

- 1 ~ e 2
( p - ) 2 2 2

dp

Rearranging yields:

p*

- 1 ~ e 2

( p - ) 2 2 2

dp
( p*- ) 2 2 2

- 1 = p * ~ e 2

p*

- 1 ~ e 2

( p - ) 2 22

- 1 dp + p ~ 3e 2 p*

( p - ) 2 2 2

(A.29) dp

Applying (A.23) allows the computation of the last integral:


Appendix A

375
( p - ) 2 2 2

p*

2 p

- 1 ~ e 2

dp (A.30)

= 2 p * f (p*) + 2 (1 - F(p*)) + 2 (1 - F(p*)) + 2 f (p*) = 2 (p * + )


f (p*) + 2 + 2 (1 - F(p*)) p * - 2 2 = (p * + ) + +

) 1 - p *-

Defining fN(p) and FN(p) as normal density and normal distribution functions,
respectively, and (p) and (p) as standard normal density and standard normal
distribution functions, respectively, yields finally:
E (P 2 P > p*) = =

2 (p * + ) f N ( p*) + 2 + 2 (1 - FN (p*)) (1 - FN (p*)) f N (p*) + 2 + 2 (1


- FN (p*))

= 2 (p * + )

) ( )

(A.31)

p * - p * - 2 2 = (p * + ) 1 - + +

For the relative version of the model the conditional relative offer is computed by
the division of E(P|P>p*) by :

E ( 2 > *) = 2 ( * +1) f R (*) + 2 + 1 (1 - FR ( *)) * -1 = ( * +1)

) * -1 1 - + (

(
+1

(A.32)

A.4.3. Conditional Expected Offer and Conditional Expected Square Offer Below the
Reservation Price The conditional expected offer and the conditional expected
square offer below the reservation price (purchase case) can be computed
analogically yielding: E ( < *) = 1 - 2 f R (*) * -1 * -1 = 1 - FR (
*) (A.33)
376 E ( 2 < *) = 2 (1 - *) f R (*) / FR (*) + 2 + 1 * -1 * -1 2 = (1
- *) + +1

Appendix A

)
(A.34)

A.5.

Closed Form Solutions for the Variance of et Sale Receipts and the Variance of et
Purchase Expense

The closed form formula for V() is to be derived. From the general property of
variance, it holds that: V() = E() E() (A.35)

The formula for E() has been derived in Appendix A.2, so that only the formula for
E() needs to be derived:
-( - ) Tj -( - ) Ti j< i i + Ti e < * E( 2 ) = E (1 + A Ti ) e
i i = ... i =1 - 0 0 -
i j i i -( - ) t j -( - ) t k j=1 (1 + a t ) e k =1 + tj e j i j=1
j=1

i i Pr( i = i i > *) (1 - FR (*)) FR-1 (*) di dFT ( t j ) dFA (a ) j=1

= ... i =1 - 0 0 -

i i -2 ( - ) t j j=1 2 (1 + a t ) 2 e j i j=1

+ 2 i (1 + a t j ) e
j=1

-( - ) t j
j=1

tj e
j=1

-( - ) t k
k =1

j
j i -( - ) t k k =1 + t j e j=1

i i Pr( i = i i > *) (1 - FR (*)) FR-1 (*) di dFT ( t j ) dFA (a ) j=1

(A.36)

Extending the above expression yields three addends that are considered separately:
Appendix A
Add1 = ... i =1 - 0 0

i i - 2 ( - ) t j j =1 E ( 2 > *) (1 + a t ) 2 e j j=1

377

(A.37)

i (1 - FR (*)) FR-1 (*) dFT ( t j ) dFA (a ) j=1


i
Add 2 = ... i =1 - 0 0
i j i i - ( - ) t j - ( - ) t k j=1 2 E( > *) (1 + a t ) e k =1 tj e
j j =1 j =1 (A.38)

i i (1 - FR (*)) FR-1 (*) dFT ( t j ) dFA (a ) j =1

Add 3 = ... i =1 0 0

j i i -( - ) t k i k =1 t e (1 - FR ( *) ) FR-1 ( *) dFT ( t j ) j
j=1 j=1

(A.39)

For further derivations, it is convenient to define the following variables: X1 =


e - t ( - ) e - t dt =
0

( - ) + 2( - ) + (A.40)

X 2 = e - 2 t ( - ) e - t dt =
0

Y1 = te - t ( - ) e - t dt =
0

(( - ) + )2 (2( - ) + )2
2 (2( - ) + )3

Y2 = te - 2 t ( - ) e - t dt =
0

Z 2 = t 2e - 2 t ( - ) e - t dt =
0

X1, X2, Y1, Y2, and Z is equal for all time intervals ti and can be employed to
simplify the notation of the addends Add1, Add2, and Add3 when computing integrals.
Furthermore, the fact that the expected value of the market uncertainty factors is
zero means

that
-

a dFA (a ) = 0 .
378 The first addend can be simplified as follows:
Add1 = ... i =1 - 0 0
i i - 2 ( - ) t j j=1 E( 2 > *) (1 + a t ) 2 e j j=1

Appendix A

i i i (1 - FR (*)) FR-1 (*) dFT ( t j ) dFA (a ) j=1 j=1

= ... i =1 - 0 0

i 2 i i E( 2 > *) 1 + 2 a t + a 2 t e -2(- ) j1t j = j j


j=1 j=1

(A.41)

i i (1 - FR (*)) FR-1 (*) dFT ( t j ) dFA (a ) j=1

Computing integrals over a as well as t1 to ti and substituting according to (A.40)


yields:
i Add1 = E ( 2 > *) X i2 (1 - FR (*)) FR-1 ( *) i =1

] ] ]
(A.42)

i + E (A 2 ) E ( 2 > *) i Z 2 X i2-1 (1 - FR (*)) FR-1 ( *) i =1

i + E (A 2 ) E ( 2 > *) E (A 2 ) i (i - 1) Y22 X i2-2 (1 - FR (*)) FR-1


(*) i =2

Since > , X2 is always positive and smaller than one, and the infinite sums are
always finite. As long as the variance of A, i.e. E(A) = A is finite, Add1 is
also finite and equals:
Add1 = + E ( 2 > *) X 2 (1 - FR (*)) 2 E ( 2 > *) Z 2 (1 - FR (*)) + A (1
- X 2 FR (*)) (1 - X 2 FR (*))2

2 2 E ( 2 > *) Y22 (1 - FR (*)) FR (*) A

(A.43)

(1 - X 2 FR (*))3

The second addend can be simplified as follows:


Appendix A
Add 2 = ... i =1 - 0 0
i j i i -( - ) t j -( - ) t k j=1 2 E ( > *) (1 + a t ) e k =1 tj e j
j=1 j=1

379

i i (1 - FR (*) ) FR-1 ( *) dFT ( t j ) dFA (a ) j=1 = 2 E( > *) (1 -


FR (*))

(A.44)

... i=1 0 0

i j i -(-) t j i -( - ) t k i j=1 e k =1 FR-1 (*) dFT ( t j ) tj e j=1


j=1

Integrating and substituting according to (A.40) yields:


i i j i Add 2 = 2 E( > *) (1 - FR (*)) FR-1 (*) Y2 X 2-1 X1- j i =1
j=1 i i X 2 - X1 i = 2 E( > *) (1 - FR ( *)) Y2 FR-1 (*) X 2 - X1 i
=1

(A.45)

Since due to the assumption that > both X1 < 1 and X2 < 1, the infinite sum is
always finite and can be simplified as follows:
Add2 = 2 E( > *) (1 - FR (*)) Y2 (1 - X1 FR (*)) (1 - X 2 FR (*))

(A.46)

The third addend can be simplified as follows:


Add3 = ... i =1 0 0

j i i -( - ) t k i k =1 t e (1 - FR (*)) FR-1 (*) dFT ( t j ) j j=1


j=1

= ... 0 i =1 0

2 j i -( - ) t k k =1 t j e j=1
m n

(A.47)

i i-1 -( - ) t k -( - ) t k k =1 k =1 + 2 tm e tn e m =1
n =m +1 i >1 i i (1 - FR (*)) FR-1 (*) dFT ( t j ) j=1
380

Appendix A

Rearranging the sums and substituting for integrals over t according (A.40) yields:
Add 3 = 2 (1 - FR ( *) )
i i -1 i i j-1 k - j-1 j-1 i FR-1 ( *) Z 2 X 2 + 2 FR-1 (*)
Y1 Y2 X1 X2 i=1 j=1 i=2 j=1 k = j+1 i X -1 i = 2 (1 - FR ( *) )
Z 2 FR-1 ( *) 2 X2 -1 i =1 i i X ( X - 1) + X 2 ( X1 - 1) - X1 + X 2
i + 2 Y1 Y2 FR-1 (*) 1 2 ( X1 - 1) ( X 2 - 1) ( X 2 - X1 ) i =2

(A.48)

Since due to the assumption that > both X1 < 1 and X2 < 1, the infinite sum is
always finite and can be simplified as follows: Z2 Add 3 = 2 (1 - FR ( *) )
(1 - FR (*) ) (1 - X 2 FR ( *) ) 2 Y1 Y2 FR ( *) + 2 (1 - FR ( *) ) (1
- FR (*)) (1 - X1 FR (*)) (1 - X 2 FR (*)) = = 2 2 Y1 Y2 FR ( *) 2 Z2
+ (1 - X 2 FR (*)) (1 - X1 FR (*)) (1 - X 2 FR (*)) 2 (Z 2 (1 - X1 FR
( *) ) + 2 Y1 Y2 FR ( *) ) (1 - X1 FR (*)) (1 - X 2 FR (*))

(A.49)

Summing up the three sums yields:


E ( 2 ) = + E( 2 > *) X 2 (1 - FR (*)) 2 E( 2 > *) Z 2 (1 - FR (*)) + A
(1 - X 2 FR (*)) (1 - X 2 FR (*))2

(1 - X 2 FR (*))3 2 E( > *) (1 - FR (*)) Y2 + (1 - X1 FR (*))(1 - X 2 FR


(*)) 2 (Z 2 (1 - X1 FR (*)) + 2 Y1 Y2 FR (*)) + (1 - X1 FR (*)) (1 - X 2
FR (*))

2 2 E( 2 > *) Y22 (1 - FR (*)) FR (*) A

(A.50)

Finally, the following variance formula yields:


Appendix A
V ( ) = + E ( 2 > *) X 2 (1 - FR (*)) 2 E ( 2 > *) Z 2 (1 - FR (*)) + A
(1 - X 2 FR (*)) (1 - X 2 FR (*))2

381

(1 - X 2 FR (*))3 2 E ( > *) (1 - FR (*)) Y2 + (1 - X1 FR (*))(1 - X 2 FR


(*)) 2 (Z 2 (1 - X1 FR ( *)) + 2 Y1 Y2 FR ( *)) + (1 - X1 FR (*)) (1 - X 2
FR (*)) 2 E ( > *) X1 (1 - FR ( *)) + Y1
- 1 - X1 FR ( *)

2 E (A 2 ) E ( 2 > *) Y22 (1 - FR (*)) FR (*)

(A.51)

The variance of the expense at purchase can be computed analogically yielding:

V ( ) = + +

2 2 E ( 2 < *) Y22 (1 - FR (*)) FR (*) A

E( 2 < *) FR (*) X 2 2 E( 2 < *) Z 2 FR (*) + A (1 - X 2 (1 - FR (*)))


(1 - X 2 (1 - FR (*)))2

(1 - X 2 (1 - FR (*)))3

(1 - X1 (1 - FR (*))) (1 - X 2 (1 - FR (*))) 2 (Z 2 (1 - X1 (1 - FR (*))) +


2 Y1 Y2 FR (*)) + (1 - X1 (1 - FR (*))) (1 - X 2 (1 - FR (*)))
E ( < *) X1 FR (*) + Y1 - 1 - X1 (1 - FR (*))
A.6.
2

2 E ( < *) FR (*) Y2

(A.52)

Covariance between et Sale Receipts

The formula for the covariance between expected net receipts from the sales of two
properties is to derive. Two variants are considered separately. In the Variant A,
the correlation between unexpected market changes (AX and AY) is independent of the
time horizon to which they refer. In the Variant B, the correlation between AX and
AY refers only to the time period in which both assets remain unsold. A.6.1.
Variant A Receipts from the sale of assets X and Y are defined as follows:
382 X ,i = X,i (1 + A X TX ,k ) e
k =1 j i
-( - Y ) TY , n
n =1 k

Appendix A + Tk X e
k =1 j i
-( - X ) TX , n
n =1 k

(A.53)

Y , j = Y, j (1 + A Y TY ,k ) e
k =1

-( - Y ) TY , n
n =1

+ TY ,k Y e
k =1

-( - Y ) TY , n
n =1

(A.54)

Covariance can be computed with a simplified formula as follows: cov(X , Y ) = E (X


Y ) - E(X ) E (Y ) (A.55)

The sale of X takes place when the respective offer exceeds the reservation price X
and the sale of Y takes place when the respective offer exceeds the reservation
price Y. Hence, the covariance can be formulated as follows (one expectation
operator is used for all random variables):
k k i i -( -Y ) TY ,n -( -X ) TX ,n n =1 n =1 + Tk X e cov(x , Y ) = E
X,i (1 + A X TX ,k ) e k =1 k =1 k k j j -( -Y ) TY , n -( -Y ) TY ,n n
=1 n =1 > , > Y, j (1 + A Y TY ,k ) e + TY ,k Y e X X Y Y k =1 k
=1

(A.56)

-( -Y ) TY ,n -( -X ) TX ,n n =1 n =1 - E X,i (1 + A X TX ,k ) e + Tk X
e X > X k =1 k =1 k k j j -( -Y ) TY ,n -( -Y ) TY , n n =1 n =1 E Y,
j (1 + A Y TY ,k ) e + TY ,k Y e Y > Y k =1 k =1
i
k

For better tractability, the conditions of X and Y exceeding the respective


reservation prices X and Y are omitted in the following derivations. Furthermore,
following substitutions are applied:
j i ~ ~ TX ,i = TX ,k and TY , j = TY ,k k =1 k =1
(A.57)
k n =1

X = e

-( -X ) TX , n
n =1

and Y = e
k n =1

-( -Y ) TY , n

(A.58)
-( - Y ) TY , n
n =1 k

H X = Tk X e
k =1

-( - X ) TX , n

and H Y = TY ,k Y e
k =1

(A.59)
Appendix A

383

Applying these simplifications allows for the following presentation for the
covariance formula:
~ ~ cov(x , Y ) = E X (1 + A X TX ) X + H X Y (1 + A Y TY ) Y + H Y ~ ~ -
E X (1 + A X TX ) X + H X E Y (1 + A Y TY ) Y + H Y ~ ~ = E X X + X A
X TX X + H X Y Y + Y A Y TY Y + H Y ~ ~ - E X X + A X X TX X +
H X E Y Y + Y A Y TY Y + H Y ~ = E X X Y Y + X X Y A Y TY
X + X X H Y ~ + X A X TX X Y Y ~ ~ ~ + X A X TX X Y A Y TY
Y + X A X TX X H Y ~ + H X Y Y + H X Y A Y TY Y + H X H Y ~ ~ - E
X X + X A X TX X + H X E Y Y + Y A Y TY Y + H X

( (( ( (

[(

) (

)(

)( ) (

)] )) )
(A.60)

) (

Utilizing the fact that random variables referring to X and to Y are independent
except from AX and AY, which are correlated with each other but independent of all
other variables, the covariance of receipts can be rewritten as:
cov(x , Y ) =

~ = E ( X X ) E ( Y Y ) + E ( X X ) E (A Y ) E Y TY Y ~ + E ( X X )
E(H Y ) + E(A X ) E X TX X E ( Y Y ) ~ ~ + E(A X A Y ) E X TX X E Y
TY Y ~ + E(A X ) E X TX X E (H Y ) + E(H X ) E ( Y Y ) ~ + E(H X ) E (A
Y ) E Y TY Y + E(H X ) E (H Y ) ~ - E ( X X ) E ( Y Y ) - E ( X X )
E(A Y ) E Y TY Y ~ - E ( X X ) E(H Y ) - E(A X ) E X TX X E ( Y Y )
~ ~ - E (A X ) E X TX X E(A Y ) E Y TY Y ~ - E (A X ) E X TX X E(H
Y ) - E(H X ) E( Y Y ) ~ - E (H X ) E(A Y ) E Y TY Y - E(H X ) E(H Y )

( ) ( )
) )

( (

) )

(A.61)

Applying the fact that the expected values of both AX and AY are zero and
simplifying yields:
~ ~ cov(x , Y ) = E(A X A Y ) E X TX X E Y TY X

) (

(A.62)
384 For further simplification consider the following expression:
( - ) Tj ~ j E T = E ( Tj )e > * j i i ( - ) t j j=1 =
... i t j e i =1 - 0 j=1 0

Appendix A

(A.63)

i i Pr( i = i i > *) (1 - FR (*)) FR-1 (*) dFT ( t j ) di j=1

Integrating over i yields:


~ E T = ... i =1 0 0

i i ( - ) t j j=1 E ( > *) t e j j=1

(A.64)

i (1 - FR (*)) FR-1 (*) dFT ( t j ) j=1


i

Assuming exponential distribution of t1 to ti and substituting for FT(.) yields:


~ E T = ... i =1 0 0

i i E ( > *) t j e t j ( -) j=1 j=1

i t i (1 - FR (*)) FR-1 (*) e j dt j j=1

= ... i =1 0 0

i i E ( > *) t j e t j ( -+ ) j=1 j=1

i i (1 - FR (*)) FR-1 (*) dt j j=1

= E ( > *) i ( - + ) 2 i =1

-+

i -1

(1 - F (*)) Fi-1 (*) R R


i

]
(A.65)

1 1 - FR ( *) FR ( *) = E ( > *) i - + FR (*) i=1 ( + - )

Finally, computing the sum, which is finite if FR (*) < + - , yields:


Appendix A ~ E T = = E ( > *) = 1 - FR ( *) FR (*) ( + - ) 1 + - FR
(*) ( - + (1 - FR (*)))2

385

(A.66)

E ( > *) (1 - FR (*))

( - + (1 - FR (*)))2

The result can be alternatively expressed as: E ( > *) (1 - FR (*)) Y1 ~ E T =


(1 - X1 FR (*)) 2

(A.67)

with: X1 =

( - ) +

and

Y1 =

(( - ) + )2

Applying this result to (A.62) yields and assuming E (A X A Y ) to be known and


equal
XY yields the following covariance formula:

cov(X Y ) = XY

E ( X X > X *) 1 - FR X ( X *) Y1,X

E ( Y Y > Y *) 1 - FR Y ( Y *) Y1,Y (1 - X1,Y FR Y ( Y *)) 2

(1 - X1,X FR X ( X *))

(A.68)
The assumption of normally distributed offers allows further simplification:
cov(x , Y ) * - 1 * - 1 * - 1 * - 1 + X X 1 - Y + Y
Y = XY 1 - X Y Y X X Y1,X Y1,Y 2 2 * * 1 -
X1,X X - 1 1 - X1,Y Y - 1 X Y

(A.69)

A.6.2. Variant B ~ If the TX is chosen as the (shorter) reference time horizon, the
market change factor ~ ~ for the asset Y, (1 + A Y TY ) can be split in two parts:
the part referring to TX and the part referring the time before or after the sale
of X. Thus:
386 ~ ~ ~ ~ (1 + A Y TY ) = (1 + A Y TX ) 1 + A Y (TY - TX )

Appendix A

(A.70)

~ ~ Respectively, if TY is the shorter reference horizon, the (1 + A X TX ) can


then be split as follows: ~ ~ ~ ~ (1 + A X TX ) = (1 + A X TY ) 1 + A X (TX - TY )

(A.71)

Only A Y is correlated to AX and A X is correlated to Ay, A Y and A X are


independent of all other variables. The relation between AX and A Y and between A X
and Ay is assumed to be defined by the covariance coefficient of XY and XY
respectively. According to the definition of A within the model as unexpected
changes, also A X , A X ,
A Y , and A Y have expected values of zero.

Consider the case when TX is the reference horizon. For better tractability rental
revenues are omitted and the simplified notation from Version A is applied.

~ ~ cov X , Y TX < TY ~ ~ ~2 ~ ~ = E X (1 + A X TX + A Y TX + A X A Y TX ) X
Y 1 + A Y (TY - TX ) Y ~ ~ - E X (1 + A X TX ) X E Y (1 + A Y TY ) Y

[ (

) (

) ]

(A.72)

Recognizing that only AX and A Y are correlated and conducting a simplification


analogical to the one in Variant B leads to the following covariance formula:
~ ~ ~ ~ ~2 ~ cov T X , Y TX < TY = E X Y (A X A Y TX ) e -(-X ) TX e -(-Y )
TY X ~ ~ ~2 = E (A X A Y ) E( X TX e -( -X ) TX ) E( Y e -( -Y ) TY )

) [
]

(A.73)

Resolving the expectation operator yields:


Appendix A

387

~ ~ ~ cov T X , Y TX < TY =
X

i = X Y E ( X X > * ) 1 - FR ,X ( * ) FR-,1 (* ) X X X X i =1 j=1 j E ( Y Y


> * ) 1 - FR ,Y (* ) FR-1 (* ) Y Y ,Y Y

2 X i (( - X ) + X )3 + i (i - 1)

X ( - ) + X X

i -1

2X (( - X ) + X )4

= X Y E ( X X > * ) 1 - FR ,X (* ) E ( Y Y > * ) X X Y 1 - FR ,Y (* ) Y

X ( - ) + X X

i-2

j Y ( - Y ) + Y

1 (( - X ) + X )2
i j

X Y i j-1 * FR-,1 (* ) i (i - 1) X X ( - ) + FR ,Y ( Y ) ( - )
+ i =1 j=1 X X Y Y

E ( Y Y > * ) 1 - FR ,Y (* ) Y Y Y ( - Y ) + Y
R ,Y

( (1 - F

* Y

) ))

(A.74)

2 X Y FR ,X (* ) 2X E( X X > * ) 1 - FR ,X (* ) X X X

(( - X ) + X ) (( - X ) + X (1 - FR ,X (* ) )) X
~

Analogically, the covariance in the case of TY being the shorter reference horizon
equals:

~ ~ cov X , Y TX > TY =

E( X X > * ) 1 - FR ,X (* ) X X X ( - X ) + X
R ,X

( (1 - F

* X

) ))

(A.75)

2 XY FR ,Y (* ) 2Y E( Y Y > * ) 1 - FR ,Y (* ) Y Y Y

(( - Y ) + Y ) (( - Y ) + Y (1 - FR ,Y (

* Y

))

)
3

Analytical derivation of the unconditional covariance requires the computation of


probabilities of one asset being sold earlier that the other. This proves, however,
to be very difficult, if at all possible, when continuous time is assumed. Due to
the lack of a satisfactory solution of this problem no closed form formula for the
covariance of net
388

Appendix A

receipts can be provided here. A numerical solution can be applied when precision
of the covariance estimation with the method presented in the Variant A is not
satisfactory.
Appendix B

B.1.

Statistics of the GAA Data on Condominium Transactions in Selected German Urban


Areas

All condominium prices and their statistics (means and standard deviations) are in
Euro per square meter; transaction volumes are in thousands of Euros. Two-digit
precision is used in most cases.

Duisburg
Mean 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 1359.15 1350.35 1381.68
1518.60 1346.11 1368.61 1396.00 1585.96 1539.45 1304.64 1415.06 Good Quality Stand.
Volume Dev. 259.61 3,344.41 311.97 4,742.45 362.25 4,518.57 300.39 4,169.84 292.19
3,798.93 287.30 2,248.35 322.83 4,295.80 455.36 1,801.39 352.18 1,416.00 373.84
2,884.90 331.79 3,322.06 Number 36 49 45 38 39 23 41 15 12 30 32.80 Mean 1179.02
1232.88 1214.68 1208.70 1191.98 1172.80 1021.32 1085.71 1094.62 1167.03 1179.02
Medium Quality Stand. Volume Dev. 359.78 19,267.56 306.29 15,572.95 345.78
20,204.08 348.80 14,657.22 323.96 9,126.65 345.93 12,018.55 383.07 11,557.41 455.56
16,791.58 441.09 16,435.08 406.84 7,511.60 359.78 14,314.27 Number 232 176 232 170
106 142 157 219 207 92 232.00

Frankfurt
Mean 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2,412.13 2,277.79 2344.96
Good Quality Stand. Volume Dev. 757.41 15,702.97 701.56 17,060.65 729.48 16,381.81
Number 71 81 95 79 77 79 80 80 93 107 84 Mean 1,724.19 1,650.15 1687.17 Medium
Quality Stand. Volume Dev. 606.91 47,311.77 623.76 55,214.02 615.34 51,262.90
Number 388 357 405 403 376 431 366 332 392 478 393
390

Appendix B

Hannover
Mean 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 1,573.57 1,479.92 1,543.24
1,433.87 1,489.45 1,465.41 1,422.81 1,240.96 1,413.18 1,343.94 1,440.64 Good
Quality Stand. Volume Dev. 275.57 12,378.19 317.29 431.34 304.79 308.06 325.81
379.34 168.64 360.61 327.55 319.90 13,615.07 14,519.59 10,199.91 10,531.92
11,266.83 10,445.67 9,168.22 13,056.34 10,332.95 11,551.47 Number 119 130 141 103
107 119 111 101 149 120 119.98 Mean 1,434.65 1,439.60 1,360.53 1,266.33 1,257.28
1,178.43 1,147.25 1,130.49 1,131.19 1,062.17 1,440.64 Medium Quality Stand. Volume
Dev. 239.93 55,899.92 301.97 263.69 280.20 288.74 252.27 294.88 299.80 377.79
417.75 319.90 61,485.66 65,570.47 46,062.78 47,562.17 50,880.98 47,172.66 41,403.69
58,962.44 46,663.60 11,551.47 Number 537 589 635 466 484 538 502 455 671 540 119.98

Kln
Mean 1,930.44 Good Quality Stand. Volume Dev. 630.50 Number 4,050 Mean 1,673.51
Medium Quality Stand. Volume Dev. 437.03 Number 8,133

Stuttgart
Good Quality Mean 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 1,666.77
1,658.73 1,532.71 1,523.45 1,484.56 1,467.38 1,466.67 1,481.77 1,512.40 1,459.77
1,513.25 1,524.31 Stand. Dev. 358.14 356.11 263.15 272.68 260.33 222.08 248.44
259.82 311.02 266.62 261.91 280.03 Volume 13,638.71 15,631.26 15,077.82 21,194.14
19,078.68 15,223.83 14,086.92 17,750.05 19,155.59 15,367.12 22,824.01 17,184.38
Number 122 142 147 202 190 151 145 175 188 158 220 167.27 Mean 1,951.02 1,807.50
1,799.33 1,751.89 1,748.48 1,674.18 1,718.26 1,718.19 1,732.10 1,718.80 1,758.03
1,761.62 Stand. Dev. 329.93 343.62 308.22 319.95 375.14 340.47 358.67 354.00 385.22
351.32 329.75 345.12 Medium Quality Volume 38,169.38 38,746.84 35,763.08 41,709.65
44,614.06 35,353.69 38,479.66 44,470.38 38,562.29 41,058.73 46,716.61 40,331.31
Number 288 311 292 348 375 306 324 376 317 345 382 333.09
Appendix B

391

B.2.

Summary Statistics of Sale Receipts generated in a MC Simulation


Frankfurt M Duisburg M Frankfurt G Duisburg G Stuttgart M 1.41 0.07 1.51 3.08 1.40
0.08 1.46 2.78 1.36 0.08 1.43 2.46 1.70 0.57 -0.16 9.25 1.49 0.07 1.29 3.05 1.44
0.07 1.40 2.80 Hanover M Cologne M Hanover G Stuttgart G 1.36 0.07 1.51 2.93 1.34
0.07 1.42 2.51 1.30 0.08 1.34 2.12 1.60 0.29 -0.15 9.53 1.41 0.06 1.22 2.43 1.36
0.07 1.38 3.11 Cologne G

Maximal Reservation Price, = 5% Mean Standard Deviation Skewness Kurtosis 1.62


0.13 1.47 2.67 1.55 0.09 1.48 2.73 1.34 0.11 1.25 1.72 1.65 0.12 1.44 2.67 1.44
0.14 1.27 1.82 1.84 0.13 1.52 2.89 1.40 0.09 1.41 2.52 1.59 0.08 1.44 2.44

Maximal Reservation Price, = 25% Mean Standard Deviation Skewness Kurtosis 1.60
0.13 1.37 2.22 1.53 0.10 1.51 2.95 1.28 0.12 1.13 1.35 1.60 0.13 1.43 2.39 1.40
0.15 1.24 1.91 1.78 0.13 1.44 2.51 1.38 0.09 1.37 2.31 1.55 0.09 1.56 3.23

Maximal Reservation Price, = 50% Mean Standard Deviation Skewness Kurtosis 1.55
0.13 1.36 2.42 1.49 0.10 1.33 1.92 1.21 0.13 1.06 1.20 1.53 0.14 1.38 2.28 1.34
0.16 1.16 1.54 1.70 0.14 1.37 2.15 1.34 0.10 1.28 1.94 1.50 0.09 1.47 2.71

Minimal Reservation Price, = 5% Mean Standard Deviation Skewness Kurtosis 2.01


0.37 -0.19 8.80 1.90 0.44 -0.13 8.68 1.60 0.35 -0.44 7.97 1.96 0.23 -0.33 7.67 1.89
1.23 -0.18 6.28 2.27 0.46 -0.39 9.88 1.66 0.23 -0.29 9.67 1.85 0.18 -0.25 8.68

Minimal Reservation Price. = 25% Mean Standard Deviation Skewness Kurtosis 1.74
0.11 1.13 2.38 1.65 0.09 1.37 2.93 1.35 0.11 0.85 1.78 1.72 0.12 1.22 2.05 1.52
0.14 0.70 2.24 1.90 0.12 1.47 3.27 1.48 0.08 1.10 2.36 1.64 0.08 1.39 2.59

Minimal Reservation Price. = 50% Mean Standard Deviation Skewness Kurtosis 1.66
0.12 1.36 2.86 1.58 0.09 1.37 2.57 1.27 0.12 0.84 1.23 1.63 0.12 1.23 2.01 1.43
0.14 0.92 1.99 1.81 0.13 1.43 2.83 1.41 0.09 1.24 2.29 1.58 0.08 1.43 2.99
392

Appendix B

B.3.

Summary Statistics of Returns Corrected for Search Effects in a Planned Liquidation


Frankfurt M Duisburg M Frankfurt G Duisburg G Stuttgart M 1.65 15.0 31.7 0.17 0.31
0.29 0.38 0.08 0.53 -0.06 0.24 0.64 1.00 0.24 8.3 21.2 0.21 0.37 0.34 0.44 0.10
0.66 -0.07 0.28 0.75 1.00 Hanover M Cologne M Hanover G Stuttgart G 1.55 12.4 17.4
0.25 0.32 0.43 0.54 0.21 0.57 0.05 0.36 1.00 0.64 0.63 6.8 13.2 0.29 0.37 0.48 0.60
0.26 0.71 0.05 0.40 1.00 0.75 Cologne G

Liquidation Strategies Maximizing Expected Returns Reservation Price Expected


Return (%) Return Volatility (%) 1.94 16.9 23.5 1.84 16.5 24.5 1.55 11.7 12.8 1.89
15.3 14.9 1.83 16.3 32.2 2.19 19.7 19.4 1.60 12.7 20.1 1.79 15.1 14.1

Correlations Cologne G Cologne M Duisburg G Duisburg M Frankfurt G Frankfurt M


Hanover G Hanover M Stuttgart G Stuttgart M 1.00 0.52 0.37 0.44 0.27 0.35 0.30 0.09
0.25 0.17 0.52 1.00 0.25 0.23 0.14 0.46 0.12 0.23 0.32 0.31 0.37 0.25 1.00 0.53
0.11 0.26 0.30 0.07 0.43 0.29 0.44 0.23 0.53 1.00 0.19 0.33 0.11 0.10 0.54 0.38
0.27 0.14 0.11 0.19 1.00 0.16 0.57 0.07 0.21 0.08 0.35 0.46 0.26 0.33 0.16 1.00
-0.02 0.35 0.57 0.53 0.30 0.12 0.30 0.11 0.57 -0.02 1.00 0.08 0.05 -0.06 0.09 0.23
0.07 0.10 0.07 0.35 0.08 1.00 0.36 0.24

Liquidation Strategies Minimizing Return Volatilities Reservation Price Expected


Return (%) Return Volatility (%) 0.36 7.5 17.5 0.46 7.9 16.2 0.78 6.8 10.0 0.69 7.3
12.0 0.36 7.8 17.6 0.88 9.7 10.1 0.38 6.6 17.6 0.72 7.7 11.4

Correlations Cologne G Cologne M Duisburg G Duisburg M Frankfurt G Frankfurt M


Hanover G Hanover M Stuttgart G Stuttgart M 1.00 0.60 0.41 0.49 0.33 0.43 0.33 0.10
0.29 0.21 0.60 1.00 0.29 0.27 0.17 0.57 0.14 0.27 0.37 0.37 0.41 0.29 1.00 0.57
0.13 0.32 0.33 0.08 0.48 0.34 0.49 0.27 0.57 1.00 0.23 0.42 0.12 0.11 0.60 0.44
0.33 0.17 0.13 0.23 1.00 0.19 0.75 0.09 0.26 0.10 0.43 0.57 0.32 0.42 0.19 1.00
-0.03 0.44 0.71 0.66 0.33 0.14 0.33 0.12 0.75 -0.03 1.00 0.08 0.05 -0.07 0.10 0.27
0.08 0.11 0.09 0.44 0.08 1.00 0.40 0.28
Appendix B

393

B.4.

Exemplary Efficient Portfolios with a Liquidity Decision Criterion

Implicit Spread as Liquidity Criterion


Mean Return Frankfurt G Duisburg G Hanover G Stuttgart G Cologne G Return
Volatility 0.84% 0.84% 0.81% 0.79% 0.76% 0.78% 0.77% 0.79% 0.84% 0.85% 0.84% 0.90%
0.89% 0.95% 0.94% 1.01% 1.00% 1.08% 1.05% 1.15% 1.12% 1.23% 1.19% 1.32% 1.28% 1.42%
1.37% 1.29% 1.48% 1.38% 1.58% 1.47% 1.68% 1.58% 1.80% 1.82% Implicit Spread 1.111
1.109 1.115 1.121 1.133 1.140 1.151 1.171 1.161 1.167 1.188 1.173 1.185 1.178 1.187
1.184 1.192 1.190 1.200 1.196 1.205 1.201 1.210 1.207 1.215 1.213 1.221 1.310 1.226
1.300 1.232 1.308 1.238 1.316 1.244 1.275

Sale Res. Price Purch. Res. Price P16 P32 P48 P64 P80 P96 P112 P128 P144 P160 P176
P192 P208 P224 P240 P256 P272 P288 P304 P320 P336 P352 P368 P384 P400 P416 P432
P448 P464 P480 P496 P512 P528 P544 P560 P576

1.65 0.07 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.03 0.00 0.00 0.04 0.00 0.01 0.00
0.00 0.00 0.00 0.00 0.01 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.24 0.00 0.19
0.00 0.20 0.00 0.21 0.00 0.07

1.28 1.43 1.41 0.18 0.15 -8.06 Asset Weights 0.86 0.02 0.04 0.92 0.06 0.00 0.89
0.09 0.00 0.81 0.09 0.00 0.71 0.13 0.00 0.61 0.12 0.00 0.56 0.20 0.00 0.52 0.26
0.00 0.64 0.35 0.00 0.57 0.36 0.00 0.44 0.31 0.00 0.55 0.40 0.00 0.40 0.35 0.00
0.52 0.44 0.00 0.36 0.39 0.00 0.50 0.47 0.00 0.32 0.41 0.00 0.47 0.50 0.00 0.28
0.44 0.00 0.43 0.54 0.00 0.24 0.46 0.00 0.40 0.57 0.00 0.20 0.49 0.00 0.38 0.61
0.00 0.18 0.54 0.00 0.35 0.64 0.00 0.16 0.58 0.00 0.04 0.42 0.00 0.15 0.62 0.00
0.00 0.48 0.00 0.11 0.65 0.00 0.00 0.52 0.00 0.07 0.68 0.00 0.00 0.57 0.00 0.04
0.71 0.00 0.00 0.70 0.00

1.35 0.18 0.08 0.02 0.03 0.09 0.15 0.27 0.24 0.19 0.01 0.08 0.22 0.05 0.24 0.04
0.25 0.03 0.27 0.03 0.28 0.03 0.30 0.03 0.31 0.02 0.28 0.01 0.26 0.31 0.22 0.33
0.24 0.28 0.25 0.23 0.25 0.23 6.18% 6.18% 6.23% 6.28% 6.38% 6.44% 6.54% 6.64% 6.64%
6.69% 6.74% 6.74% 6.79% 6.79% 6.85% 6.85% 6.90% 6.90% 6.95% 6.95% 7.00% 7.00% 7.05%
7.05% 7.10% 7.10% 7.15% 7.20% 7.20% 7.26% 7.26% 7.31% 7.31% 7.36% 7.36% 7.41%
394

Appendix B

Liquidity Risk Reward as Liquidity Criterion


Frankfurt G Frankfurt G Duisburg G Duisburg G Hanover G Stuttgart G Hanover G
Stuttgart G Cologne G Cologne G Mean Return (in %) Asset Weights Reservation Prices
Liq. Risk Reward 5.24 5.76 6.30 5.98 4.91 7.04 6.11 7.57 6.80 7.73 7.02 7.79 7.08
7.77 7.18 7.71 7.21 7.60 7.26 6.19 7.22 6.33 7.06 6.31 6.85 6.23 6.61 6.24 6.37
6.05 6.13 5.75 5.25 5.57 5.04 5.37 4.90 5.19 4.76 5.01 4.58 4.81 4.29 4.48 Return
Volatility (in %) 0.80 0.81 0.84 0.83 0.81 0.88 0.86 0.94 0.90 0.98 0.93 1.01 0.96
1.04 1.00 1.08 1.04 1.12 1.09 1.06 1.16 1.11 1.21 1.17 1.26 1.22 1.32 1.30 1.40
1.37 1.47 1.39 1.41 1.48 1.48 1.56 1.57 1.67 1.67 1.79 1.78 1.88 1.88 1.92

P16 P32 P48 P64 P80 P96 P112 P128 P144 P160 P176 P192 P208 P224 P240 P256 P272 P288
P304 P320 P336 P352 P368 P384 P400 P416 P432 P448 P464 P480 P496 P512 P528 P544
P560 P576 P592 P608 P624 P640 P656 P672 P688 P704

0.08 0.10 0.12 0.12 0.11 0.15 0.14 0.17 0.16 0.19 0.18 0.20 0.19 0.22 0.21 0.23
0.23 0.25 0.25 0.23 0.28 0.25 0.30 0.29 0.33 0.32 0.35 0.34 0.38 0.38 0.41 0.39
0.30 0.43 0.31 0.45 0.34 0.48 0.37 0.51 0.39 0.51 0.36 0.43

0.45 0.39 0.34 0.37 0.44 0.26 0.33 0.18 0.26 0.14 0.22 0.12 0.19 0.10 0.15 0.07
0.12 0.05 0.07 0.15 0.03 0.10 0.00 0.06 0.00 0.03 0.00 0.00 0.00 0.00 0.00 0.00
0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

0.08 0.08 0.08 0.13 0.22 0.09 0.17 0.07 0.16 0.08 0.16 0.09 0.18 0.11 0.19 0.13
0.19 0.14 0.19 0.29 0.19 0.28 0.20 0.27 0.23 0.28 0.25 0.29 0.27 0.31 0.29 0.34
0.43 0.36 0.46 0.38 0.48 0.41 0.51 0.43 0.54 0.47 0.60 0.55

0.11 0.12 0.14 0.09 0.00 0.15 0.06 0.19 0.09 0.21 0.09 0.22 0.09 0.21 0.09 0.21
0.10 0.21 0.12 0.00 0.15 0.02 0.15 0.01 0.14 0.00 0.12 0.05 0.12 0.05 0.11 0.00
0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

0.28 0.30 0.33 0.30 0.23 0.35 0.30 0.38 0.33 0.38 0.34 0.37 0.35 0.36 0.36 0.35
0.37 0.34 0.37 0.33 0.36 0.34 0.35 0.36 0.31 0.37 0.27 0.32 0.22 0.27 0.18 0.27
0.27 0.22 0.23 0.17 0.17 0.11 0.12 0.06 0.07 0.02 0.05 0.01

1.58 1.57 1.55 1.56 1.57 1.54 1.55 1.53 1.54 1.52 1.53 1.52 1.53 1.52 1.53 1.52
1.52 1.52 1.52 1.53 1.52 1.53 1.52 1.53 1.52 1.52 1.52 1.52 1.52 1.52 1.52 1.52
1.54 1.52 1.54 1.53 1.54 1.53 1.54 1.53 1.54 1.53 1.55 1.54

1.19 1.19 1.19 1.19 1.19 1.19 1.19 1.19 1.19 1.20 1.19 1.20 1.20 1.21 1.20 1.22
1.21 1.23 1.22 1.21 1.25 1.22 1.13 1.23 1.08 1.25 1.04 1.06 1.01 0.92 1.13 1.00
1.00 1.01 1.00 1.05 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00

1.34 1.34 1.33 1.31 1.31 1.31 1.30 1.32 1.30 1.31 1.29 1.31 1.29 1.30 1.29 1.30
1.29 1.29 1.29 1.28 1.29 1.28 1.29 1.29 1.29 1.29 1.29 1.29 1.29 1.29 1.29 1.29
1.28 1.29 1.28 1.29 1.29 1.29 1.29 1.29 1.29 1.29 1.29 1.29

1.36 1.35 1.34 1.35 1.22 1.33 1.36 1.32 1.35 1.32 1.35 1.32 1.35 1.32 1.35 1.32
1.34 1.32 1.34 1.39 1.34 1.39 1.34 1.06 1.34 -.04 1.35 1.37 1.35 1.38 1.36 1.03
1.00 1.05 1.00 1.10 1.00 0.01 1.00 1.10 1.00 1.00 1.00 1.00

1.30 1.30 1.29 1.30 1.31 1.29 1.30 1.29 1.29 1.29 1.29 1.29 1.29 1.29 1.29 1.29
1.29 1.29 1.29 1.30 1.29 1.30 1.29 1.30 1.30 1.30 1.30 1.30 1.31 1.31 1.31 1.31
1.31 1.31 1.32 1.32 1.32 1.33 1.33 1.34 1.34 1.35 1.34 1.35

6.53 6.57 6.61 6.65 6.69 6.69 6.73 6.73 6.77 6.77 6.81 6.81 6.85 6.85 6.88 6.88
6.92 6.92 6.96 7.00 7.00 7.04 7.04 7.08 7.08 7.12 7.12 7.16 7.16 7.20 7.20 7.24
7.27 7.27 7.31 7.31 7.35 7.35 7.39 7.39 7.43 7.43 7.47 7.47
Appendix B

395

Expected Receipts and Receipts' Volatility as Independent Liquidity Criteria


Return Volatility (in %) Frankfurt G Frankfurt G Duisburg G Duisburg G Exp.
Receipts (in %) 1.43 1.42 1.41 1.36 1.38 1.45 1.41 1.46 1.51 1.44 1.44 1.46 1.41
1.46 1.51 1.39 1.48 1.50 1.56 1.42 1.52 1.59 1.42 1.52 1.56 1.59 1.62 1.47 1.52
1.59 1.42 1.44 1.50 1.55 1.55 1.57 1.47 1.46 1.48 1.53 1.52 1.54 1.49 1.50 1.46
1.48 1.45 Mean Return Asset Weights Hanover G Stuttgart G Cologne G Cologne G
Reservation Prices Hanover G Stuttgart G Receipts' Volat. (in %). 0.07 0.06 0.05
0.07 0.05 0.06 0.06 0.09 0.11 0.08 0.06 0.06 0.06 0.07 0.08 0.07 0.07 0.08 0.11
0.07 0.09 0.12 0.08 0.09 0.11 0.12 0.15 0.08 0.09 0.12 0.09 0.09 0.09 0.11 0.11
0.11 0.10 0.09 0.10 0.11 0.10 0.11 0.12 0.11 0.10 0.10 0.12

P64 P96 P160 P192 P256 P288 P352 P384 P448 P480 P544 P576 P640 P672 P736 P768 P832
P864 P928 P960 P1056 P1120 P1152 P1216 P1248 P1312 P1344 P1408 P1440 P1536 P1600
P1632 P1696 P1728 P1792 P1824 P1888 P1920 P1984 P2016 P2080 P2112 P2176 P2208 P2272
P2304 P2400

0.30 0.24 0.23 0.13 0.18 0.33 0.23 0.37 0.52 0.30 0.30 0.34 0.25 0.35 0.51 0.21
0.41 0.47 0.71 0.29 0.55 0.77 0.24 0.54 0.66 0.79 0.92 0.43 0.57 0.86 0.27 0.38
0.51 0.61 0.69 0.76 0.37 0.43 0.46 0.55 0.58 0.64 0.49 0.41 0.45 0.48 0.40

0.25 0.14 0.11 0.33 0.08 0.09 0.11 0.24 0.08 0.19 0.02 0.01 0.01 0.01 0.00 0.13
0.00 0.00 0.00 0.00 0.00 0.00 0.04 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

0.00 0.03 0.07 0.30 0.14 0.06 0.18 0.18 0.00 0.24 0.15 0.13 0.22 0.17 0.07 0.38
0.19 0.15 0.01 0.31 0.17 0.04 0.41 0.22 0.15 0.08 0.01 0.35 0.27 0.10 0.49 0.43
0.36 0.30 0.26 0.22 0.49 0.46 0.44 0.39 0.37 0.34 0.44 0.53 0.51 0.49 0.59

0.22 0.31 0.24 0.00 0.23 0.23 0.11 0.00 0.15 0.00 0.25 0.32 0.13 0.14 0.20 0.00
0.10 0.15 0.17 0.07 0.19 0.19 0.00 0.05 0.00 0.12 0.07 0.12 0.13 0.04 0.00 0.03
0.06 0.00 0.05 0.03 0.00 0.00 0.03 0.00 0.03 0.00 0.00 0.00 0.01 0.01 0.00

0.24 0.28 0.34 0.23 0.37 0.30 0.37 0.22 0.25 0.27 0.28 0.20 0.38 0.33 0.21 0.28
0.30 0.23 0.10 0.33 0.08 0.00 0.31 0.19 0.19 0.00 0.00 0.10 0.03 0.00 0.24 0.16
0.08 0.09 0.00 0.00 0.14 0.11 0.06 0.06 0.01 0.02 0.07 0.06 0.03 0.02 0.01

1.59 1.54 1.53 1.50 1.49 1.55 1.53 1.65 1.65 1.61 1.52 1.53 1.49 1.54 1.56 1.57
1.56 1.55 1.58 1.48 1.54 1.59 1.57 1.56 1.59 1.58 1.60 1.51 1.53 1.55 1.49 1.47
1.52 1.60 1.53 1.53 1.53 1.49 1.50 1.56 1.53 1.54 1.65 1.57 1.48 1.49 1.65

1.24 1.22 1.22 1.21 1.18 1.25 1.21 1.28 1.28 1.26 1.26 1.27 1.25 1.27 1.25 1.19
1.25 1.26 1.21 1.17 1.24 1.29 1.18 1.25 1.25 1.29 1.17 1.13 1.13 1.17 1.13 1.13
1.13 1.20 1.19 1.17 1.13 1.10 1.10 1.13 1.13 1.13 1.12 1.12 1.18 1.21 1.12

1.29 1.39 1.33 1.25 1.25 1.38 1.29 1.43 1.27 1.39 1.31 1.33 1.26 1.33 1.39 1.24
1.35 1.35 1.42 1.24 1.35 1.42 1.28 1.36 1.41 1.41 1.43 1.27 1.32 1.39 1.24 1.24
1.29 1.39 1.33 1.34 1.28 1.25 1.26 1.34 1.30 1.33 1.19 1.32 1.24 1.25 1.17

1.37 1.33 1.33 1.24 1.29 1.35 1.34 1.25 1.41 1.25 1.33 1.33 1.31 1.36 1.37 1.19
1.38 1.37 1.39 1.30 1.36 1.39 1.19 1.40 1.22 1.40 1.40 1.34 1.37 1.40 1.17 1.32
1.38 1.21 1.39 1.40 1.18 1.39 1.37 1.20 1.39 1.18 1.17 1.17 1.19 1.38 1.16

1.33 1.31 1.29 1.26 1.27 1.32 1.29 1.35 1.35 1.34 1.30 1.31 1.27 1.31 1.33 1.23
1.32 1.33 1.35 1.26 1.34 1.18 1.28 1.34 1.35 1.18 1.17 1.32 1.35 1.19 1.26 1.27
1.33 1.35 1.41 1.20 1.32 1.30 1.32 1.35 1.35 1.35 1.14 1.35 1.31 1.33 1.14
6.69 6.74 6.80 6.86 6.86 6.86 6.92 6.92 6.92 6.97 6.97 6.97 7.03 7.03 7.03 7.09
7.09 7.09 7.09 7.15 7.15 7.15 7.20 7.20 7.20 7.20 7.20 7.26 7.26 7.26 7.32 7.32
7.32 7.32 7.32 7.32 7.38 7.38 7.38 7.38 7.38 7.38 7.39 7.43 7.43 7.43 7.48

1.00 1.06 1.03 0.91 1.06 1.13 1.04 1.08 1.37 1.06 1.24 1.38 1.18 1.23 1.48 1.14
1.31 1.42 1.93 1.28 1.71 2.20 1.30 1.56 1.77 2.24 2.57 1.64 1.83 2.41 1.49 1.57
1.73 1.81 2.05 2.17 1.64 1.68 1.77 1.81 1.92 1.96 1.77 1.80 1.85 1.88 1.94
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