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in Germany ISBN 978-3-8349-1004-2
To Helena
Foreword
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.
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
XIII
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
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
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
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
Tables
$ 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
Abbreviations
XXVII
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,
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
~ l l0 L Liq ln(.)
XXXI
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
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
~
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
Introduction
be easily redefined for the application to any asset provided the required
parameters can be assessed with sufficient precision.
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
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
1.1.
Definition of Liquidity
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
1.1 Definition of Liquidity
13
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
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
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
Price
Y'
Z'
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.
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
16
17
18 19
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
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
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
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
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.
Cash Ratio =
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.
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
See also Hicks (1974), Chapter 2, for an in-deep discussion of liquidity risk. See
FN 3.
30
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
typical or expected duration of the selling process might exist, but it will always
be burdened with uncertainty.39
Present value
Time Figure 1-8: Liquidity risk as the uncertainty of the liquidation value
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
b)
c)
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
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
Volume
Selling price
Purchasing price
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
47
37
Asset Liquidity
Time Price
Market Liquidity
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
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
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
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
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
43
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.
54 55
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
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
----
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
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
63
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.
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
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
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.
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
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
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
59
79
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
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
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
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
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
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
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
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
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
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
Valuation
Valuation
Valuation
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
73
1.3.
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
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
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
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
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
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
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
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
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
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
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
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
134 135
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
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
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.
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
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
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.
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 -
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
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
95
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
Utility
Z Y
Y'
Z'
Wealth
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
Risk
Manageability
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
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.
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
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.
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
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
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.
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
178
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
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
2.2.
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
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
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*.
Offer P2 P2<p*2
P2>p*2
Offer P3 P3<p*3
P3>p*3
...
Sale price of Pi
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
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
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
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
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)
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)
- 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
g f (g) dg = g dF(g)
-
(2.5)
with: f(.)
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)
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:
p dF(p)
1 - F(p*)
(2.8)
119
(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
(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
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)
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
121
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
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)
(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)
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)
(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.
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
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
1 f (p) = e ~ 2
-( p - )2 22 -( x - )2 2 2
(2.21)
1 F(p) = e ~ 2 -
with: ~
dx
-( x - )2 22
(2.22) e
-x 2 2
dx =
1 ~ 2
dx
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
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
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.
= 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
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.
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
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
(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
(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
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:
~ 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.
- 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.
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)
234
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
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:
Time invariance of the search problem requires that Et() = Et+1() = E().
Considering it yields after rearrangement:
E ( ) =
(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
E ( ) =
(2.37)
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
141
1,2
0,8
0,6
0,4
0,2
*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
Following parameters were used: offer volatility () = 15%; trend () = 5%; rental
income () = 5%; discounting rate () = 15%; offer frequency () = 52.
142
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.
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.
144
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
146
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.
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
(2.40)
...
(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).
148
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
( ( (
) ) )
(2.42)
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.
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
150
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
151
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).
152
259
260
153
See Karni/Schwartz (1977) and Landsberger/Peled (1977) for search models with
uncertain recall.
154
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.
262
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)
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
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.
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:
c+ 1 - F(p ) B
(2.45)
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
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
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
Is > *?
No
Rental revenues ()
Figure 2-3: Scheme of a Monte Carlo Simulation for the real estate sale process
162
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
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
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
0,8
0,6
0,4
0,2
Figure 2-5: Locus of expected net sale receipts and search duration in 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
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.
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
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
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
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
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.
173
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).
174
288
289
290
291
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
(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
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:
(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
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
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.
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
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
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
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.
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
185
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
187
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
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
3.2.
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
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
331
332
194
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
340
341
342 343
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) =
197
3.3.
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
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
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
Goal Variable
tmin
tmax
Goal Variable
tmin
Goal Variable
Goal Variable
350
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
(X - E(X))
f ( X ) dX
(3.23)
(3.24)
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
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
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 ) = +
2 E( 2 > *) Z 2 (1 - 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
(3.28)
206
(3.29)
(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
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
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
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
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.
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
(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 =
M - Tj e
j=1
~ -( - )Tj
(3.34)
~ ~ (1 + A Ti ) e -( -)Ti
1,2
Default probability
0,8
0,6
0,4
0,2
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
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
367
215
SV() = E (max(0; E () - ) 2 )
(3.35)
(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
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
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.
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)
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
where the risk aversion parameter corresponds with a certain confidence level x%
satisfying the following condition:382 Pr(discount < LVaR())=x% (3.39)
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
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.
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
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
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
(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)
(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)
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
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.
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
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
229
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
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
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.
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
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
Cumulative probability
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
U'2 Y
U'1
X Z
Standard Deviation
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
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
407
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)
Correlation = +1
Correlation = 1
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
Expected Returns
U3
MERP POPT
U2 MVP U1
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
U Expected Returns
POPT
PM
410
See also Sharpe/Alexander (1990), pp. 166 ff., or Elton et al. (2003), pp. 84 ff.
242
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
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
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
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
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
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
251
1,2
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
Receipts' Volatility
252
1,4
X
1,2
0,8
0,6
0,4
0,2
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
1,295
U3
U2
U1
MaxE
1,285
*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
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?
255 (4.6)
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
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
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
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
0,8
0,4
Receipts' Volatility
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
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
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
1,4
1,2
0,8
*opt
0,6
0,4
0,2
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
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
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
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
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
0,7
0,5
Receipts' Volatility
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
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.
427
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
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
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
273
Expected receipts
Y Receipts' volatility
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
275
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
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.
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
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
has explicitly been excluded from the analysis, also this group of approaches
remains disregarded.
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.
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
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).
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
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
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
(4.14) - the maximal and the minimal value of the liquidity meas-
285
a)
b)
287
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)
(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
(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
~ ~ 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
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.
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
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
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
448 449
297
Vola tility
0
RR) ity (L
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
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
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
wi = 1
i =1
with: p ,i E
p ,i UE
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
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
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.
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
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.
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
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
5.1.
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
See also the discussion in section 2.4 and Figure 2-6. See FN 267.
5.1 Determination of Model Parameters
311
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
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
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.
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.
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
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.
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
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.
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
with: Pt Ht
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
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
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
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.
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.
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
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
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.
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
1204 67 132 49 71 32
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
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
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
60
Frankfurt M Hanover G
40
20
Reservation Price
=50%
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
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
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
337
all figures in %
LRR ( = 5%) Reservation Prices LRR ( = 25%) Reservation Prices LRR ( = 50%)
Reservation Prices
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.
Stuttgart M
Cologne M
Hanover G
Stuttgart G
Cologne G
338
339
2,2 Cologne G
1,8
Frankfurt G Frankfurt M
1,6
1,4
Stuttgart M
=5%
1,9
1,7
=25%
340
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
=50%
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.
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
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
n (n - 1)
(5.2)
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
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
Time on Market
Receipts' Volatility
Def. Probability
Receipts' Semivolatility
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
347
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.
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)
476
477
all figures in %
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
Expected Return
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
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.
353
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
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%
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%
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)
357
5.3.
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
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
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
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
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
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.
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*-
(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)
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.6)
(A.7)
(A.8)
369
( - )
(A.9)
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 (*)))
(A.13)
E () =
(A.14)
with: X1 =
( + - )2
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.
E () =
(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
(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.
A.4.1. Conditional Expected Offer The conditional expected offer under normal
distribution of offers is to be computed:
p*
p dF(p)
1 - F(p*) (A.21)
( 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
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:
p*
dF(p) (A.26)
1 - F(p*)
Appendix A
( p - ) 2 2 2
x (p) = - y(p) = 1
( p - ) - ~ e 2 3
( p - ) 2 2 2
(A.27)
( 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
(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
375
( p - ) 2 2 2
p*
2 p
- 1 ~ e 2
dp (A.30)
) 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 * + )
) ( )
(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 :
) * -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 =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
(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)
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)
( - ) + 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 =1 - 0 0
(A.41)
] ] ]
(A.42)
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
(A.43)
(1 - X 2 FR (*))3
379
(A.44)
... i=1 0 0
(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)
= ... 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)
(A.50)
381
(A.51)
V ( ) = + +
(1 - X 2 (1 - FR (*)))3
2 E ( < *) FR (*) Y2
(A.52)
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)
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
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)
(A.64)
= ... i =1 0 0
= E ( > *) i ( - + ) 2 i =1
-+
i -1
]
(A.65)
385
(A.66)
E ( > *) (1 - FR (*))
( - + (1 - FR (*)))2
(A.67)
with: X1 =
( - ) +
and
Y1 =
(( - ) + )2
cov(X Y ) = XY
E ( X X > X *) 1 - FR X ( X *) Y1,X
(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)
(A.71)
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)
) [
]
(A.73)
387
~ ~ ~ cov T X , Y TX < TY =
X
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
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.
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.
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. = 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.
393
B.4.
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
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
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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