Eric-Weinstein.net

Analytic and Strategic Consulting

FINANCE / HEDGE FUNDS / RISK MANAGEMENT

Problem

Hedge funds invest in privately traded securities whose true value is obscured by many conflicting indicative prices estimated by a small collection of broker dealers.

Partners and Sponsors

Capital Market Risk Advisors (CMRA) and AdKap L.L.C.

Challenge

Come up with a system that allows a full extension of standard financial tools to analyze these ‘translucent’ securities, while at the same time incorporating the lack of a reliable price.

Customized Toolkit

For this problem we chose an approach using the risk calculus of von Neumann - Morgenstern together with choices of functional forms from probability theory (modified Gamma and Beta Distributions) and Arrow-Pratt risk aversion.

Solution

Treat the blizzard of indicative prices as a source of additional risk so that risk averse investors should expect additional compensation as the prices spread out. Then use the indicative prices as if they were a random sample from a probability distribution governing the true price. Use the risk aversion of the investor to discern a certainty equivalent in the form of a definite spot price of a hypothetical liquid security. Because the spot price exists while the equivalent liquid security does not exist, we called certainty equivalent the phantom price.

Publications

And Talks

Hedge Fund Transparency: Quantifying Valuation Bias for Illiquid Assets in RISK, June 2002, pg. S25.

Phantom Prices & Liquidity: the nuisance of translucence, Chapter Eight of A Guide to Fund of Hedge Funds Management and Investment, L. Rahl Editor, AIMA, 2002

Spot Prices: Fact or Fiction? Risk or Reward? MIT ‘View of the Markets’ lecture, JP Morgan, New York.

Contact

If your interests are related to this topic, please contact us at finance@eric-weinstein.net or by visiting us at our website: www.transparentrisk.com.

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