Managing hedge fund liquidity risks
Résumé
Hedge fund optimal portfolios are studied in the presence of market and funding liquidity risks. We consider a two-period economy with a singlehedge fund. The fund has access to cash, which is available every period, and to an illiquid asset, which pays off only at the end of the secondperiod. Funding liquidity risk takes the form of a random proportion of the fund’s assets under management being withdrawn by clients in periodone. The fund can then liquidate a part of the illiquid position by bidding on a secondary market where a random haircut on the effective sellingprice is applied. We solve the allocation problem of the fund and find its optimal portfolio. Whereas the cash buffer is monotonously decreasing inthe secondary market liquidity, we show that the fund’s default probability is bell-shaped.