Market Liquidity - March 11, 2008

Interview with François-Serge Lhabitant

In this month's interview, we speak to François-Serge Lhabitant, Associate Professor of Finance at EDHEC Business School and Chief Investment Officer with Kedge Capital, about his new book, "Stock Market Liquidity: Implications for Market Microstructure and Asset Pricing."

François-Serge Lhabitant

"Stock Market Liquidity: Implications for Market Microstructure and Asset Pricing" covers a large number of topics, with contributions from around 40 academics. Are there any common trends in this research or lessons that can be drawn for the practising professional?

François-Serge Lhabitant: Liquidity plays a central role in the “normal” functioning of financial markets. We have been in a long period characterized as one of exceptional liquidity and this has greatly contributed to the ongoing expansion in the world economy. But it has also encouraged the development of irrational bubbles, as all assets were perceived as liquid with small transaction costs, easy and timely settlement and each trade had virtually no impact on prices. Today, all this is over – liquidity is scarce and expensive. Some market professionals as well as investors are learning it the hard way. Let us mention hedge funds subject to redemptions; money market funds experiencing NAV losses; medium sized banks sharply exposed to mortgages; insurance companies facing downgrades; SIVs and conduits backed by asset-based commercial paper; non financial companies trying to fund their regular activities; etc. The central banks’ lender of last resort support might help banks, but financial disintermediation and securitization have brought so much outside of the banking system that the consequences of a liquidity problem are massive.

In such an environment, it is essential to understand and model liquidity and its possible changes over time in order to assess the quality of an investment as well as its price. And this is still true today: the current crisis will trigger great investment opportunities in the next two to four years – but only if you know how to manage liquidity.

Liquidity is notoriously one of the most difficult aspects of financial markets to model for academics. Do you think that progress has been made in this area and does your book shed any new light on the subject?

François-Serge Lhabitant: When market liquidity and funding are abundant, all can easily be measured, like interest rates and credit spreads. But when liquidity ebbs, the effect is conspicuous in market prices, volumes, and costs. Measuring and modelling liquidity – or illiquidity – is therefore tricky, because you essentially need to model something that you cannot observe and do not even know how to measure precisely. This explains why for many years, academics have assumed frictionless markets.

Fortunately, significant progresses have been made in that field, initially in the market microstructure area, and more recently in the risk management and asset management area. The goal of our book was therefore to collect the relevant research on liquidity and make it available in a single volume.

You co-wrote a chapter in this book on "Managing Illiquidity". Could you give us a quick synopsis of this chapter and would there be any practical examples of illiquidity from recent events in the markets?

François-Serge Lhabitant: Our chapter essentially reviews the various methods available to hedge funds if they want to invest in illiquid and hard to price assets while still having an indefinite life, accepting new subscriptions and redemptions on a regular basis, and charging their investors both a management and a performance fee based on marked to market returns. We in particular discuss items such as side pockets, gates, lockups, and compare the private equity funds and the hedge fund structures.

There are numerous examples of recent hedge fund problems in the past weeks where investors suddenly realized that their monthly or quarterly asset had turned into a large illiquid investment and that it is going to take several years to realize its value. This occurred because the underlying positions were structurally illiquid (e.g. real estate), because the underlying positions became illiquid (e.g. credit-related positions today) or where the position size was too large to be considered as liquid (e.g. small caps, some activist funds, etc.).

Your three previous publications with Wiley were on the subject of hedge funds. Does this examination of stock market liquidity correspond to a new orientation for your research?

François-Serge Lhabitant: Not really. Note that I also published books on emerging markets (Eastern Europe) and commodities trading (CTAs), and I am now working on a book on Global Asset Management in general.

About François-Serge Lhabitant

François-Serge Lhabitant is currently the Chief Investment Officer at Kedge Capital. He was formerly a Member of Senior Management at Union Bancaire Privée, where he was in charge of quantitative risk management and subsequently, of the quantitative research for alternative portfolios. Prior to this, Francois-Serge was a Director at UBS/Global Asset Management, in charge of building quantitative models for portfolio management and hedge funds.

On the academic side, François-Serge is currently a Professor of Finance at EDHEC Business School (France) and at the University of Lausanne (Switzerland). He was formerly a visiting professor at the Hong Kong University of Science and Technology, held the Deloitte & Touche Chair on Risk Management at the University of Antwerp (Belgium), and was an associate professor of finance at Thunderbird, the American Graduate School of International Management.

François' specialist skills are in the areas of quantitative portfolio management, alternative investments (hedge funds) and emerging markets. He is the author of several books on these subjects and has published numerous research and scientific popularisation articles (listed on www.lhabitant.net). He is also a member of the Scientific Council of the Autorité des Marchés Financiers, the French regulatory body.

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