Illiquidity premium private, simple, ideas, loans

JoeyDVivre

Anyone got any ideas on how best (preferably simple) ways to calculate illiquidity premiums for private debt/loans ?

Thanks in advacne

jacksparrow

Yeah, all the theoretical models are ultimately crap given all the inputs are really subjective to a certain extent anyways, just have to look behind another curtain to find the one pulling the levers.

I like where the other conversation between you guys is going though - good stuff.

NakedPuts

I see your point mobius and agree. never thought of that...

OK Take 2,

How about using covered bonds?

Liquidity premium = covered bond index yield - swap yield ?

yodacaia

@transferpricingcfa
you are implicitly assuming that there is no liquidity premium in the CDS market which is not true, there are large bid-ask spreads there and certain tenors wont trade at all or very rarely. there are academic studies attempting to quantify what portion of the CDS premium is pure default risk premium vs. illiquidity premium, with limited success. so you've just shifted your problem from "illiquidity in bond markets" to "illiquidity in CDS markets" without finding an answer unfortunately

@betaprivate
i agree with you that simple is good (if thats what you meant)! the reason why i wouldnt use these models in fixed income setting is not because they are too simple (or too complex), i just dont believe they produce anything more reliable than randomly adding a spread (of 25bps if you will) - even though they have the appearance of being so quantitative. they are a bit more trustworthy in the equity space cause more research and empirical support was done there, but only by a small margin...

anshultongia

Thanks for the answers so far guys, but...

How about this,

A comparison of yields on a risk free liquid bond with an equivalent position in corporate bonds protected against default risk using CDS.

liquidity premium = corp bond spread - CDS premium??

So its like comparing a liquid risk free bond against an illiquid risk free bond?

mar350

Mobius:

To his point:

>>> dude, I said uncomplicated!

So that's what I threw out there. I agree all those theories have holes in them and have been discussed more in the equity domain. The other comment on interest rate calls and mean reversion is also interesting. Can you explain that more? The math on that? Frankly I don't do much fixed income work so I'm just curious.

It is indeed a true cost of illiquidity, not marketability, since there are no restrictions. Still, the 25 bps just doesn't pass the gut check for me if you're really trying to figure out the fair market value of the note. Could you really find a buyer for a transaction cost of 25 bps? That sounds really low to me.....

therecruit

@ betaprivate, i wouldnt jump into any of these put models here for a few reasons:
1) it's a theory built on shaky academic grounds with many holes to fill in
2) rigorous academic research (if any) and empirical support for such models resides exclusively in the equity space. you cant just transalate any of these results into the fixed income area without substantial modifications and additional support
3) even if you could, it certainly wouldnt happen in the simple way you outlined above. you are pricing some sort of put option where the underlying is a bond with black-scholes, thats like doing brain surgery with a meat cleaver. you'll need to formulate it as a call option where the underlying is interest rate and apply a mean-reverting model such as Vasicek instead of simple GBM
4) what the heck is a "holding period" here anyway? there are no absolute trading restrictions on the bond, just large bid-ask spreads but you can in principle sell it at any time, even tomorrow
5) finnerty and asian put, isnt that one and the same

@transferpricingcfa, your best bet is dig out some empirical data and dont touch any of this "theory". however, i think that in general for bonds it is very hard to separate credit risk premium from illiquidity premium. Longstaff has some work on the subject but i dont think there is anything conclusive. if your benchmark issues are far more liquid than the instrument you are pricing, higgmond's approach of adding a few bp and calling it a day might be your best bet



Edited 1 time(s). Last edit at Tuesday, April 19, 2011 at 01:19PM by Mobius Striptease.

AndyNZ

Well I would guess that is just about as good as info on market stats as you could get. I just wonder how the heck they calculate that. I'm guessing that's ASC 820 stuff, and I can't imagine the auditors are cool with a rule of thumb. I would seriously love to know how they come up with it.

yospaghetti

Beta Private Wrote:
-------------------------------------------------------
> Do you know a market maker of a private note with
> no rating not registered with the SEC at a 25 bps
> spread?
>
> I completely agree that if you have market
> information on spreads or agent commissions that
> is 100 percent the way to go. Just wondering
> where you're getting your rule of thumb from.
>
> Not knocking it, just want to know - that's good
> info.

I do consulting work for a well know BDC. They typically add 25 bp for their non-traded notes when valuing their portfolio. These are $250 MM offerings though, so a larger premium would probably be applicable to smaller issues. I don't know how much more though.

yospaghetti

Do you know a market maker of a private note with no rating not registered with the SEC at a 25 bps spread?

I completely agree that if you have market information on spreads or agent commissions that is 100 percent the way to go. Just wondering where you're getting your rule of thumb from.

Not knocking it, just want to know - that's good info.